MEASURING AND CONTROLLING ASSETS

EMPLOYEDChapter 7

Adit – Bima – Estie – Inge – HanifPresented by:

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INTRODUCTION• In some business unit, focus is on PROFIT. In other

business unit, profit is compared with the assets employed.

• In real world, companies call it “Profit Center” rather than “Investment Center”• The latter is a special type of the former

• Many problems involved in measuring the assets employed in a profit center

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PURPOSE1. Provide information useful in making sound

decision about assets employed and to motivate managers to make these sound decision in the best interest of the company

2. Measure the performance of the business unit as an economic entity

Measuring Assets Employed

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PERFORMANCE OBJECTIVES1. Generate profit from the resources at their

disposal2. Invest in additional resources only when

investment will produce an adequate return

The purpose of relating PROFIT to INVESTMENT motivate business unit managers to accomplish these objectives!

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RELATING PROFIT TO ASSETS EMPLOYED1. Return on Investment (ROI)

ROI is a ratio. The numerator is income, as reported on the income statement. The denominator is assets employed.

2. Economic Value Added (EVA)EVA is a dollar amount, rather than a ratio.

EVA = Net Operating Profit – Capital ChargeThis capital charge is found multiplying the amount of assets employed by a rate.

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EVA v. ROIEVA is conceptually superior to ROI.

However, it is clear from surveys that ROI is more widely used in a

business rather than EVA.

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INVESTMENT BASE1. What practice will induce business unit manager

to use their assets most efficiently and to acquire the proper amount and kind of new assets?

2. What practices best measure the performance of the unit as an economic entity?

To decide which investment base to use, ask the following:

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1. CASH• Many companies use a formula to calculate

the cash to be included in the investment base.

• Some companies omit cash from the investment base. These companies argue that the amount of cash approximates the current liabilities.

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2. RECEIVABLES• Business unit managers can influence the level of

receivables indirectly, by their ability to generate sales, and directly by establishing credit terms and approving individual credit account.

• The usual practice is to include receivables at the book amount, which is the selling price less an amount for bad debts.

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3. INVENTORIESInventories ordinarily are treated similar to receivables recorded at end of period amount although intra period averages would be preferable conceptually.

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4. WORKING CAPITAL IN GENERAL•At one extreme, companies include all

current asset in the investment base with no offset for any current liabilities.

•At the other extreme, all current liabilities may be deducted from current assets.

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5. PROPERTY, PLANT, AND EQUPMENT• If depreciable assets are included in the investment base

at net book value, business unit profitability is misstated.• The fluctuation in EVA & ROI from year to year can be

avoided by including depreciable assets in the investment base at gross book value than net book value.

• If depreciation is determined by the annuity, rather than straight line method, the business unit profitability calculation will show the correct EVA & ROI.

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6. LEASED ASSETSThe 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 capital charge that is applied to the business unit’s investment base, because it would increase EVA.

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WHY ROI OVER EVA?1. Comprehensive measure in that anything that

affects financial statements is reflected in this ratio.

2. It is simple to calculate, easy to understand, and meaningful sense.

3. It is a common denominator that may be applied to any organizational unit responsible for profitability, regardless of size or type of business.

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WHY EVA OVER ROI?1. Profit objectives are consistent across all business units 2. Decisions that increase a centre’s ROI may decrease its overall

profits. If an investment centre’s performance is measured by EVA, investments that produce a profit in excess of the cost of capital will increase EVA and therefore be economically attractive to the manager.

3. Different interest rate may be used for different types of assets.

4. In contrast to ROI, EVA has a stronger positive correlation with changes in a company’s market value.

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EVA AND ROIEVA = Net Profit – Capital Charge

Where;

Capital Charge = Cost of Capital * Capital Employed

Another way to calculate EVA

EVA = Capital employed (ROI – Cost of capital)

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HOW TO INCREASE EVA?1. Increase in ROI through BPRE and productivity gain,

without increasing the asset base.2. Divestment of asset, product and/or businesses whose

ROI is less than the cost of capital.3. Aggressive new investment in assets, products, and/or

business whose ROI exceeds the cost of capital.4. Increase in sales, profit margins or capital efficiency or

decrease in cost of capital percentage without affecting the other variable in second equation.

DELL COMPUTER CORP.CASE STUDY

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BACKGROUND•Founded by Michael Dell in his dorm room at the

University of Texas in 1984 with $1000•Company headquartered in Round Rock, Texas, U.S.A.•World’s largest direct-selling computer company,

with 56,700 employees in >80 countries•By 2005, DELL was valued at more than $100 billion•#1 Retailer of PC, outselling IBM and HP•Uses direct selling as its key strategy

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BACKGROUND•In 2005, DELL was ranked as America’s most

admired company by Fortune, where 16.7% of computers sold in the world was a DELL machine

•Financial performance:•Revenue growth was at 19% (or 7% higher

than industry average)•Net margins of 6% (while industry lagged at

1%)

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DELL’s OBJECTIVES1. A direct relationship: the most efficient path to the

customers;

2. Custom built products and custom-tailored service: the most effective way to meet customer needs;

3. Standardised technologies: best value to customers;

4. Low-cost structure: cost savings passed to customers in form of lower prices;

5. Deliver added value to customers: customers able to obtain highest return on their investment in IT products and services.

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BUILD-TO-STOCK PC VALUE CHAIN

ComponentManuf.

PCManufacturer

Distributor/ Reseller

Order

Product Product

Forecast

Component

Components

MicroAge,CompuCom

Corporate Customer

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DELL DIRECT MODEL

Component manufacturer

DELL CompCorp

Distributor

Final Customer

Components

Order

Product

(build-to-order)

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DELL DIRECT MODELDell Computer’s direct model departed from the industry’s historical rules on several fronts:• The company outsourced all components but performed assembly;• It eliminated retailers and shipped directly from its factories to end

customers;• It took customized orders for hardware and software over the phone

or via the Internet;• It designed an integrated supply chain linking Dell’s suppliers very

closely to its assembly factories and order-intake system.

(build-to-order)

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DELL HYBRID MODELDirect

sellRetail stores

Hybrid business

model

• To augment direct sale approach, DELL set up kiosks in malls and planned a series of marketing campaigns

• By November 2004, about 15% of DELL’s revenues came from consumer electronics business

Q1What is DELL’s strategy? What is the basis on which Dell builds its competitive advantage?

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STRATEGYValue Chain Re-engineering in the PC Industry Based on trends in early 1980s:• Corporate customers getting sophisticated;

did not require personal selling• Different components of a PC became

standard modules mass customization

Q1

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STRATEGYDELL’s strategy is a combination of:• Direct Sales• Inventory Management • Supplier Integration

Maximum Effectiveness Minimum Cost

Always listen to

Customers

Never Sell Indirect

Disdain inventory

Q1

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STRATEGYResult of DELL’s Value Chain Re-engineering: • Revenue growth was at 19% (or

7% higher than industry average)• Net margins of 6% (while

industry lagged at 1%)

Q1

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COMPETITIVE ADVANTAGEDirect model successTechnology and ITShort delivery time Affordable pricesSuperior customer serviceExpansion into new productsCustomer-driven Research and DevelopmentIntegrated Supply Chain

Q1

Q2How do DELL control systems help execute the firm’s strategy?

FINANCIAL MEASURES• Return on Invested Capital• Average Selling Price• Component Purchasing Cost• Selling and Administration

Cost and Margins

Q2

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NON-FINANCIAL MEASURES• Component

inventory• Finished goods

inventory• A/R Days• A/P Days

• Cash Conversion Cycle

• Stock outs• Accuracy of

Forecast Demand

Q2

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THANK YOU!Q2