Accounting: The Language of Business - Vol. 1 (Part 144)

Managers thinking about accounting issues should never forget one of Abraham Lincoln's favorite riddles: How many legs does a dog have, if you call a tail a leg? The answer: Four, because calling a tail a leg doesn't make it a leg.

Warren Buffett

 Performance Evaluation for Decentralized Operations (Part C)

by

Charles Lamson

Responsibility Accounting for Investment Centers

In an investment center, the unit manager has the responsibility and the authority to make decisions that affect not only costs and revenues but also the assets invested in the center. Investment centers are widely used in highly diversified companies organized by division.

The manager of an investment center has more authority and responsibility than the manager of a cost center (a department within a company that does not generate revenue and is responsible for minimizing costs incurred while supporting revenue-generating departments) or a profit center ( a department that generates revenue and is responsible for maximizing profits) (fundsnetservices.com). The manager of an investment center occupies a position similar to that of the chief operating officer or president of a company and is evaluated in much the same way.

Since investment center managers have responsibility for revenues and expenses, income from operations is an important part of investment center reporting. In addition, because the manager has responsibility for the assets invested in the center, two additional measures of performance are often used. These measures are the rate of return on investment and residual income. Top management often compares these measures across investment centers to reward performance and assess investment in the centers.

To illustrate, assume that DataLink Inc. is a cellular phone company that has three regional divisions., Northern, Central, and Southern. Condensed divisional income statements for the investment centers are shown in Exhibit 6.

EXHIBIT 6 Divisional Income Statements---DataLink Inc.

Using only income from operations, the central division is the most profitable division. However, income from operations does not reflect the amount of assets invested in each center. For example, if the amount of assets invested in the Central Division is twice that of the other divisions, then the Central Division would be the least profitable in terms of the rate of return on these assets.

Rate of Return on Investment

Since investment center managers also control the amount of assets invested in their centers, they should be held accountable for the use of these assets. One measure that considers the amount of assets invested is the rate of return on investment (ROI) or rate of return on assets. It is one of the most widely used measures for investment centers and is computed as follows:

Rate of return on investment (ROI) = income from operations / investment assets

The rate of return on investment is useful because the three factors subject to control by divisional managers (revenues, expenses, and invested assets) are used in a computation. By measuring profitability relative to the amount of assets invested in each decision, the rate of return on investment can be used to compare divisions. The higher the rate of return on investments, the better the division utilizes its assets to generate income. To illustrate, the rate of return on investment for each division of Daink Inc., based on the book value of invested assets, is as follows:

                                                   Northern Division    Central Division    Southern division

 Income from operations                      $ 70,000                $ 84,000                 $ 75,000

  Invested assets                                   $350,000               $700,000                  $500,000

  Rate of return on investment                    20%                     12%                      15% 

Although the Central Division generated the largest income from operations, its rate of return on investment (12%) is the lowest. Hence, relative to the assets invested, the Central Division is the least profitable division. In comparison, the rate of return on investment of the Northern Division is 20% and the Southern Division is 15%. One way to analyze these differences is by using an expanded formula, called the DuPont formula, for the rate of return on investment. The DuPont formula, created by a financial executive of E.J. Dupont De Nemours & Co. in 1919, states that the rate earned on total assets is the product of two factors.

The first factor is the ratio of income from operations to sales, often called the profit margin. The second factor is the ratio of sales to invested assets, often called the investment turnover. Profits can be earned by either increasing the investment turnover, by increasing the profit margin, or both.

Using the DuPont formula yields the same rate of return on investment for the Northern Division, 20%, as computed previously.

Rate of return on investment (ROI) = Profit margin x Investment turnover

Rate of return on investment (ROI) = Income from operations / Sales * Sales / Invested assets

ROI = $70,000 / $560,000 X $560,000 / $350,000

ROI = 12.5% * 1.6 

ROI = 20% 

The DuPont formula for the rate of return on investment is useful in evaluating and controlling divisions. This is because the profit margin and the investment turnover focus on the underlying operating relationships of each division.

The profit margin component focuses on profitability by indicating the rate of profit earned on each sales dollar. If a division's profit margin increases, and all other factors remain the same, the division's rate of return on investment will increase. For example, a division might add more predictable products to its sales mix and thereby increase its overall profit margin and rate of return on investment.

The investment turnover component focuses on efficiency in using assets and indicates the rate at which sales are generated for each dollar of invested assets. The more sales per dollar invested, the greater the efficiency in using the assets. If a division's investment turnover increases, and all other factors remain the same, the division's rate of return on investment will increase. For example, a division might attempt to increase sales through special sales promotion or reduced inventory assets by using just-in-time principles ['Just-in-time' is a management philosophy and not a technique. It originally referred to the production of goods to meet customer demand exactly, in time, quality and quantity, whether the `customer' is the final purchaser of the product or another process further along the production line (University of Cambridge).], either of which would increase investment turnover.

The rate of return on investment, using the deposit formula for each division of DataLink Inc. is summarized as follows:

Rate of return on investment (ROI) = Income from operations / Sales X Sales / Invested assets

Northern Division (ROI) equals $70,000 / $560,000 X $560,000 / $350,000

ROI = 12.5% * 1.6

 ROI = 20%

Central Division (ROI) = $84,000 / $672,000 * $672,000 / $700,000

ROI = 12.5% * 0.96

ROI = 12%

Southern Division (ROI) = $75,000 / $750,000 * $750,000 / $500,000

ROI = 10% * 1.5

 ROI = 15%

Although the Northern and Central Divisions have the same profit margins, the Northern Division investment turnover (1.6) is larger than that of the Central Division (0.96). Thus, by using its invested assets more efficiently, the Northern Division rate of return on investment is higher than the Central Division's. The Southern Division's profit margin of 10% and investment turnover of 1.5 are lower than those of the Northern Division. The product of these factors results in a return on investment of 15% for the southern division, compared to 20% for the Northern Division. 

To determine possible ways of increasing the rate of return on investment, the profit margin and investment turnover for a division may be analyzed. For example, if the Northern Division is in a highly competitive industry in which the profit margin cannot be easily increased, the division manager might focus on increasing the investment turnover. To illustrate, assume that the revenues of the Northern Division could be increased by $56,000 through increasing operating expenses, such as advertising, to $395,000. The Northern Division's income from operations will increase from $70,000 to $77,000, as shown below.

The rate of return on investment for the Northern Division, using the DuPont formula, is recomputed as follows:

Rate of return on investment (ROI) = Income from operations / Sales * Sales / Invested assets

Northern Division revised ROI = $77,000 / $616,000 * $616,000 / $350,000

ROI = 12.5% * 1.76

 ROI = 22%

Although the Northern Division's profit margin remains the same (12.5%), the investment turnover has increased from 1.6 to 1.76, an increase of 10% (0.16 + 1.6). The 10% increase in investment turnover also increases the rate of return on investment by 10% (from 20% to 22%). 

In addition to using it as a performance measure, the rate of return on investment may assist management in other ways. For example, in considering a decision to expand the operations of DataLink Inc., management might consider giving priority to the Northern Division because it earns the highest rate of return on investment. If the correct current rates of return on investment are maintained in the future, an investment in the Northern Division will return $0.20 (20%) on each dollar invested. In contrast, investments in the Central Division will earn only $0.12 per dollar invested, and investment in the Southern Division will return only $0.15 per dollar.

A disadvantage of the rate of return on investment as a performance measure is that it may lead divisional managers to reject new Investments that could be profitable for the company as a whole. For example, the Northern Division of DataLink Inc. has an overall rate of return on investment of 20%. The minimum acceptable rate of return on investment for DataLink Inc. is 10%. The manager of the Northern Division has the opportunity of investing in a new project that is estimated to earn a 17% rate of return. If the manager of the Northern Division invests in the project, however, the Northern Division's overall rate of return will decrease from 20%. Thus, the division manager might decide to reject the project, even though the investment would exceed DataLink's minimum acceptable rate of return on investment.

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 960-964*

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