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Economic Value Added Essay

Return on Investment and Economic Value Added

This ultimately guides stakeholders to make appropriate decisions based on Information available to them to determine what the organization wants to achieve and how the performance will be measured. Organizations that are large in structure and operations focus has been to ensure shareholders wealth are maximizes which means management, investors and other takeovers require to know the performance of the organization as this will aid them to make appropriate.

We will consider the measures put in place both financial and non financial that will enable handlers of organization to have a good evaluation of the performance of the business. 1 Organizational Structures According to Tudor Spencer (2005) who stated that “No two organizations are financially managed in an identical way.

This is because different organizations have different purpose, operate in different environments, have different histories or Just managed by unique personalities with different references” (Tudor Spencer 2005; peg 130). Large organizations are grouped into divisional and non-divisional organizational structures. In dillydallied organization the structure causes a decentralization of decision making process as the central head office creates different divisions managed by divisional managers. This is the opposite in non divisional organization as responsibility for profit lies with the central head office.

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The divisional manages are given autonomy to determine profit responsibility which falls into an investment, profit or cost centre. Investment centre Investment centers are basically decentralized dollops that a manager of an organization has control and maximum discretion. The manager will determine the level and type of capital investment decision the division will handle, operating decision on product mix, pricing and various production methods for the division. Profit centre Profit centers are divisions that the managers do not have control over investments decision making process In the division.

The manager responsibility Is to ensure that profit Is generated from operations on the assets from the head office which the division reports to directly. Cost centre Cost centers are divisions where the managers are only responsible for cost but not profit. 1. 1 Divisional Performance measurement Performance evaluation of dollops can be considered In two aspects;- Return on Economic Value Added (EVA””) 1. 12 Return on Investment (ROI) The return on investment (ROI) is a performance measurement mostly used for an investment centre.

It is expresses divisional profit as a percentage of the assets employed in the operations of the division. ROI = Net income/lamented capital ROI = [Net income X Sales (Revenue) (Revenue) X Invested capital] ROI= Net refit ratio x Capital turnover The intent of this measure is to evaluate the success of an organization or division by comparing its operating income to its invested capital. The ROI is generally an objective measure used on historic accounting information. This is shown in illustration 1 under Appendix 1 where the return on investment of Company A in Division C is analyses.

Advantages of Return on Investment measurement . It can be used to make comparison among divisions with different lines of business and sizes. II. Decisions taken by a division to increase its ROI may increase he overall profitability of the organization. Ill. This measure draws the attention of the divisional manager on the assets employed in the divisions and motivates more investment in assets that an adequate return can be derived on them A division can improve ROI in two ways;

The profit margin earned per sales dollar can be increased. The sales revenue generated per dollar of invested capital can be increased (this is known as asset turnover). When a manager is evaluated only on the level of profit with no regard to asset employed the tendency would be to increase assets and therefore increase profit. Interestingly, ROI takes into account size differences across the various divisions. For example, assume the managers of divisions A and B earned $1,000,000 and $800,000 in operating income respectively.

An assumed interpretation of these differences in operating income would be that the manager of division A performed better than the manager of division B. This viewpoint may not necessarily be correct because the source of division Ass higher income may be its greater size relative to division B. This problem can be addressed when ROI is used to measure each division’s income relative to the asset base deployed. This standardizes the computation into a ratio while less attention is given to the absolute amount.

Limitations of Return on Investment measurement According to Morse, et al, (1996), the main disadvantage of ROI is that it can encourage managers, who are evaluated and rewarded based solely on this measure, to make investment divisions that are in their own best interests, while not being in the best interests of the company as a whole. L. Profit can be manipulated by managers by changing accounting policies or the use of different Judgment as noted that “Profit is a matter of opinion, cash flow is a matter of fact” II.

The use of ROI as performance measure for managers may lead to “goal incongruence”. Where a divisional manager rejects a potential project although generate a positive net present value (NAP) but ultimately reduces the manager’s ROI. Ill. The problem with using ROI to reward performance in these situations is that managers are penalized, in terms of financial compensation, for decisions made that lower their ROI while increasing the firm’s wealth. Accordingly, the manager’s conduct may lead to company’s cost of capital.

From the firm’s perspective this is viewed as dysfunctional decision making. From the manager’s perspective, the over-reliance on ROI as a performance indicator gives the manager no alternative choice. 1. Economic Value Added (EVA) According to Sahara & Kumar (2010), EVA is a measurement of the true economic profit generated by a firm. EVA is also referred to as the financial performance measure that is based on operating income after taxes, the investment in assets required to generate that income, and the cost of the investment in assets (or, weighted average cost of capital).

Hansen & Owen (1997) referred to the three elements used in calculating EVA as operating income after tax, investment in assets, ND the cost of capital. The formula to measure EVA is: EVA = Operating income after tax – (investment in assets x weighted average cost of capital). Use of EVA as a Divisional Performance measure In a decentralized organization, divisions are compared with the central head office. The use of EVA encourages divisional managers to maximize the wealth of their various divisions. The use of EVA would ensure that managers invest only in projects which the returns on the project are above the cost of capital of the organization.

– The primary strength of EVA is that it provides a measure of wealth reaction that aligns the goals of divisional or plant managers with the goals of the entire company. Disadvantage of EVA Performance measurement Although EVA has advantage over ROI, this measure has four limitations that are presented as follows; Size differences The use of EVA has no control over size differences across divisions according to Hansen & Owen (1997).

A larger division will tend to have a higher EVA when compared to smaller divisions. While EVA is more effective than ROI at aligning divisional managers’ goals with corporate goals, it has no control for size differences cross organizational units like ROI. Financial orientation EVA is relies on financial accounting methods of revenue realization and expense recognition. If motivated to do so, managers can manipulate these figures by altering their decision making processes (Horned, et al. , 1997). Managers can manipulate the revenue recognized during an accounting period by selecting which customer orders to fill and which to delay.

This is basically to increase current period EVA and an adverse blow to customer satisfaction and retention. – Discretionary expenditures can be stopped to increase EVA. – Managers ay decide not to replace completely depreciated assets and keep the equipment in its financial record. This action lowers the asset base and ensures that no depreciation expense charges are recognized. Short-term orientation The intent of a performance measurement system should be to match employees’ effort, creativity, and accomplishments with their compensation.

According to Hayes & Abernathy (1980), the authors referred in their article that although innovation, the unduly penalize failure, the predictable result of relying too heavily on short-term financial measures – a sort of managerial remote control – is an environment in which o one feels he or she can afford a failure or even a momentary dip in the bottom line. Results-orientation The financial figures prepared to determine EVA and accumulated at the end of an accounting period do not help to ascertain the main cause(s) of operational inefficiencies in a division.

These measures offer limited useful information to people charged with the responsibility of managing business processes. The reports state the obvious – that performance had declined but they do not help offer solutions to the non accounting business managers who are responsible for improving the value delivered to customers. 1. 4 Possible Solution to mitigate Short term focus of mangers EVA and other financial measures should be a major performance measurement of the organization, but should be in combination with balanced measures that encompass all the performance attributes critical to long-term success.

Kaplan and Norton (1992) created a framework tagged “balanced scorecard” that integrates four types of performance attributes that are important to long term success in an organization. These attributes are embedded in the customer perspective, the internal business process perspective, the innovation and learning perspective, and the financial respective. The strategic objectives of a company are what determine the specific measures it will include in its scorecard.

Once a clear understanding of the firm’s strategy exists, the process of formulating a balanced scorecard begins by selecting appropriate measures for each of the four perspectives. L. The customer perspective by selecting measures that define success from the customer’s point of view, such as customer retention rates, on-time delivery percentage, or surveys of customer satisfaction. II. The internal business process perspective focuses on nonofficial assure that reflect how well a firm is translating inputs into outputs that are valued by customers.

Cycle time, yield percentage, and quality defect rate are examples of internal business process measures that may be used. Ill. The innovation and learning perspective measures are leading indicators that reflect the likelihood a firm will continue to be world-class competitive in the long run. ‘V. The financial perspective is where measures such as EVA, ROI, revenue growth, and stock price make complete sense. EVA would provide useful insight into the wealth creating ability of a division or organization as a whole.

Transfer Pricing in an Organization The important feature of decentralization in large organizations is the creation of responsibility centers (e. G. Cost, profit, or investment centers). The performance of these responsibility centers is measured on the basis of various accounting investment. Transfer price is the notional value at which goods and services are transferred from one division of a company to another division in a decentralized organization. The supplying division will give intermediate goods to the receiving division while the receiving division will sell final product to the external market.

According to Dry (2009) he stated that “The objective of the receiving division is to subject the intermediate products to further processing before it is sold as a final product in the outside market. The transfer price of the intermediate product represents a cost to the receiving division and a revenue to the supplying division” (Dry 2009; peg 326). Purposes of Transfer Pricing There are some major reasons to operate a transfer pricing system:- Appropriate transfer prices will assist to coordinate the production, sales and pricing decisions of the different divisions.

Transfer prices enable the company to generate different refit figures for the various divisions which aid to measure the performance of each division separately. -Transfer prices ensures autonomy and authority is maintained in divisions. – Transfer prices would allow goal congruence. 2. 1 Methods of Transfer Pricing There are four methods of transfer pricing to be considered; Market Based Transfer Pricing In the presence of competitive and stable external markets, many organizations take the external market price as a benchmark for their internal transfer price.

Where a market exists outside the organization for the intermediate product and the market is imitative, the use of market price as the transfer price between divisions would generally lead to optimal decision making. Advantages of Market Based Transfer Price l. There are cost savings on internal transfers compared with external sales. Where significant external buying and selling costs exist then a transfer may be set lower than market price to reflect the cost savings from internal transfers. II. The circumstances may lead to negotiated market prices where the total cost savings are apportioned between the buying and selling divisions.

In such circumstances an arbitration procedure may be required but too much central intervention of this nature could undermine the autonomy of the divisions. Disadvantages of Market Based Transfer Price l. Where there is no market for the intermediate product or service being considered. II. Difficulty in obtaining a competitive price even when the market exists. Price is only strictly comparable when all features are identical- quality, delivery, finish, and so on. Ill. Market exists but is not perfectly competitive I. E.

The market is affected by the pricing decision of divisional managers. V. Market prices that are available may be considered excessive capacity in the intermediate market that current quotations are well below long run average price. In such circumstances the use of either the current, abnormally low price or the long run “normal” price may lead to sub-optimal decision making on the part of the supplying divisional management or to loss of motivation and autonomy of the purchasing division. Full Cost based transfer pricing systems are usually used because the conditions for setting ideal market prices most times do not exist.

For example there may be no intermediate market or the market which does exist may be imperfect. Where the required information is available, a decision rule that would lead to optimal decisions for the organization as a whole would be to transfer at marginal cost up to the point of transfer, plus any opportunity cost to the organization as a whole. Disadvantages of Full cost Transfer Pricing l. The autonomy of divisions would be affected as motivation to do business with other divisions will not be profitable. II. The cost may include inefficiencies of the selling division which would thus be passed on to the buying division.

Accordingly, standard cost, rather than actual costs should be used as the basis of the transfer rice in order not to burden the buying department with the inefficiencies of the supplying division. Cost-plus Mark up Transfer Pricing In this method, the transfers are made at full costs plus a profit mark up. The cost plus will be treated by the buying division as an input variable cost so that external selling price decisions based on cost may not be set at levels which are optimal as far as the firm as a whole is concerned. Disadvantages of cost-plus mark up transfer pricing l. The calculated cost is only accurate at one level of output.

II. The validity of any pricing decision base on past costs is questionable. Ill. When transfers are made at full cost plus a profit mark up the selling division receives a certain level of profit rendering genuine performance appraisal difficult. ‘V. When the selling division is inefficient or working at low volume the costs may be unacceptably high as far as the buying division is concerned. Negotiated Transfer Pricing Negotiated transfer pricing has the advantage of a free market in which divisional managers buy and sell from each other in a manner at arm’s length transactions.

However, we may not assume that the outcome of these transfer price negotiations will serve the best interests of the company or shareholders. Advantages of Negotiated Transfer Pricing l. Realistic transfer prices are achieved. II. Goal congruence is promoted among divisions of the organization. Ill. Division autonomy and motivation among the managers is achieved. Disadvantages of l. The transfer price could depend on which divisional manager is the better in bargaining rather than whether the transfer results in profit-maximizing production and sourcing decisions.

Where divisional managers fail to reach an agreement on price, even though the transfer is in the best interests of the company, senior management might decide to impose a transfer price. However, senior management’s imposition of a transfer price defeats the motivation for using a negotiated transfer price in the first place. Organizations basically would adopt the most appropriate performance measure that would increase the overall objective of the organization. This provides a complete representation of a manager’s performance and ensures a proper balance between processes and results and the short term versus the long term.

The financial measures, such as EVA and ROI recognize that ultimately a company needs to hold its people accountable for generating profits; however, the risk of overemphasized worth-run profits needs to be balanced by incorporating the non financial drivers of long-term financial wealth into the performance measurement and reward system. Devotionals organizations operating in a perfect or imperfect market would always find a way to determine the appropriate transfer pricing method to adopt. The analysis of advantages and disadvantages the different transfer methods are required to achieve the overall objective of the organization.

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