Topics

 

In this section I will deal with some issues in a detailed and, at the same time, simple way about the world of controlling, its topics, both strategic and operating ones, both the current approaches and the future trends, that is the way the companies "do it" and are going to do it and, of course, my advice.

 

49. Make the Right Price.

48. The Choice of the Kind of Bonus: Advantages and Risks

47. How Well is Your Company Using Its Money?

46. ROI: Some Strategic Sides about it and other financial performance metrics

45. Value Creation or Value "Invention"?

44. The Strategic Cost of Quality

43. The Rule of Thumb doesn’t exist

42. Why is the  Healthcare Cost Accounting so peculiar?

41. The strategic sides of Target Costing 

40. The great implications of the true Capacity Costs (PART TWO)

39. Which is the Most Profitable Customer? 

38. The Game of the Ending Inventory

37. How the "work" of the Support dpts affects the Cost Accounting Settings

36. Only Just In Time?

35. The "Way" to spot the real profitability by product

34. Risk Management: some important metrics

33. Another useful "piece" of variance analysis for the BU

32. Budgeting process: not only a numerical issue 

31. The great implications of the true Capacity Costs (PART ONE)

30. How does the Lean Accounting support the decision making?

29. The strategic interpretation of the productivity measurement (PREVIEW)

28. How deep you can dig and some strategic aspects in the variance analysis

27. Strategic distortions in the capital-budgeting project evaluation

26. Some errors in the capital-budgeting analysis

25. How and why to try to understand the real trend of the overheads

24. The cost variance analysis in the project control (INTRODUCTION)

23. The cost management and the customer-driven value model (PREVIEW)

22. What if you compete on timeliness and speed to customers?

21. The Strategic Fixed Overheads

20. The assessment of the State of the Work according to the activities

19. The choice of an appropriate costing system

18. How to deal with the uncertainty in the estimation process

17. The importance of the Product/Service Life Cycle costs

16. Resource Consumption Accounting: a comprehensive management accounting system

15. Strategic Transfer Pricing: Cost-based and Negotiated Price Methods

14. Motivation and other strategic factors in the Transfer Pricing: Market Price

13. Strategic sides of ROI

12. SBU manager evaluation: - Nonfinancial measures and strategic structure

11. How can you evaluate your business? 

10. How do you deal with the indirect costs? 

9. A very useful "piece" of variance analysis for the BU  

8. Are you getting right about the estimation of the overheads? 

7. Constraints? Here is the way to make decisions 

6. Are you customer-oriented? Here's how you can know about that 

5. Global succes indicator

4. Which kind of standard cost is it convenient to set? 

3. Joint products: how the  contribution margin is calculated  

2. ABC: - Great difference in calculating the financial variances versus the traditional costing systems 

1. The cost of the complexity

 

One of the most complicated tasks that a business has to carry out is to determine the winning price in order to hit the the desired level of profitability.

 

Why is it so complicated?

 

The answer to this question is the great range of factors to be included in this important decision.

I make a try to do a list so that you may understand the reasons why I make this statement.

 

Here is my attempt:

 

- Gathering the best product/service cost basis.

- Regrouping and channeling the cost data of the point 1 to the product /service unit to reflect the real consumption of the business resources as best as it can and according to the kind of the internal activities and their level of diversification.

- Taking into account the profitability target set by the business top management.

- Taking into account the strategy "chosen" by the top management to build a competitive advantage in the market, if it is based either on the differentiation or on the Price leadership or on a mix of the previous ones.

- Segmenting the customers according to their respective preferences towards the features/functionalities of the product/service amd their purchasing power.

- Considering the product configuration to see whether differentiating the service level of the product/service and applying the following different prices.

- Being adherent to the stage of the Life Cycle of the product/service (launch, growth, maturity, decline).

- Competitiveness level and price of the competitors.

- Seasonality of the demand.

- Inventory level

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This is the list of the main factors that come up to my mind and that one should consider in setting the right price, sometimes simultaneously.

The extent of the dissertation doesn't aim at comprising all of them but is intended to highlight, just as in all the articles posted on page Topics, the strategic side of the pricing that shouldn't be an automatic task to fulfill.

That's why the issues dealt with here will be just some of those concerned and if you want to know more, don't hesitate to get in touch on page Cpontacts of this website.

It goes without saying that the following content doesn't apply to the most part of the businesses making use of the Target Costing (see article n. 47 on page Topics) that are price takers and not price makers.

 

Let's start with spotting the different situations that a price maker should face with reference to the stage of the product/service Sales Life Cycle.

 

The first step is the Launch (or Introduction) of the product/service and the cost basis for determining the price has to include the R&D costs, and other marketing costs needed to "introducing" it in addition to the "manufacturing" ones (meaning by these the typical costs incurred to deliver the services if the the industry is the service one)  that in their turn, in case of a manufacturing company, consist also of the new production assets to make the new product.

As a result, usually it is the stage when the price the highest of the all Life Cycle.

 

The second step is the Growth and the price is initially rather stable because the demand is high and that allows the business to realize the largest profits in all the life Cycle. The competion gets stronger and the differentiation feature is not as before so at a some point the price will begin to fall

 

The third step concerns the Maturity stage when the demand increases a a lowest rate because the product is not longer something new in the market.

The cost basis should be the manufacturing costs plus the usual marketing/sales ones incurred  and if the business increases the level and the range of the services  (such as the after-sales service) and in some industry tries to enlarge the product functionalities, in order to keep the market share as untouched as possible, the related costs have to be added to the Price basis.

As a result, in consideration of the lowest value acknowledged to the product by the customers, the price falls even more and profit from that product is smaller and smaller.

 

The fourth step is the decline of the sales of the product and of the money the customer are open to spend for it decreases.

The focus of the business shifts to the control and reduction of the macnufacturing and distribution costs. It cannot leverage properly the price to be profitable.

 

If you have paid attention to what happens throughout the Sales Life Cycle, there is a clear decrease from the highest beginning price  related to the differentiation strategy (generally speaking) of the the first two steps to the lowest one related to the cost leadership of the maturity and decline steps.

As a result, this fact changes the cost basis for making the right price that shouldn't be always at the same level for the product/service and the solution is without any doubt a full Life-Cycle Costing method that wouldn't focus only on the Manufacturing dpt but would take into account all the value chain costs attributable to the product/service.

It goes without saying tha in case of a multiproduct business a correct overheads allocation "policy" should be adopted in consideration of the different Sales Life Cycle stage where each of the products is at a given point of the business life.

 

However this falls beyond the scope of the article and cannot be argued here.

 

Turning back to my statement about the appropriateness of a Full Life-Cycle Costing method, do you want an example that may include also a Profit target of a company?

 

Here it is. 

 

Let's suppose that a business estimates for the future period 20,000 Sales unit and want its ROI to add up to 15% of its  Assets, being worth $ 5,000,000.

The Unit Full Life-Cycle Cost is $ 200.

 

First of all, let's calculate the markup needed to hit 15% ROI target.

 

Markup = Assets X 15% / Unit FLCC X Expected Sales =

= 5,000,000 X 15%/ 200 X 20,000 = 18,75%

 

Then the Sales Price.

 

Price = Unit FLCC X (1 + markup) = 200 X (1,1875) = $ 237,50

 

 

Of course this price target is at a first stage an ideal one since the factors that can modify it are several and of different nature.

 

One of this elements that is consistent with the goals of the dissertations of thestrategiccontroller.com is first of all the Strategy adopted by the business to achieve a competitive advantage in its industry compared to the other competitors.

 

This "pararaph" goes beyond the natural and gradual shifts of strategy we have seen in the previous lines when writing about the Sales Life-Cycle of the product/service and it refers to the "will" of the top management to characterize their company.

 

As we have seen my time the choice is from a Cost Leadership Strategy and a Differentiation One except for some market segments where a mixed Strategy is the most appropriate.

 

Let's deal with about the classical two categories.

 

As to the industries where the Cost Leadership is pursued by their actors the Pricing is characterized by the continuos search of the lowest cost basis to which apply the markup and generally the most efficient business determines the price target of the other competitors.

 

More complex is the Price issue in the Differentiation industries where the Strategies policies are different.

The companies involved for instance can resort to a value profiling of their customer segments, spotting the features of their products/services preferred by the customers the most and channelling their expenses to those activities and resources needed to meet those preferences.

The amount resulting from this efforts are the cost basis to which applying a markup.

 

Just as an example of value profiling, here is a table showing the two segments of a pen manufacturer and the value features "weighted" by the customers

 

Table 1 -  Value Profiling of a business customers

 

Value features	Writing pen customers	High-end pen customers	Weighted Average Value
Writing Quality	55%	30%	50.2%
Model Availability	15%	10%	14.0%
Brand Name	9%	20%	11.1%
Appearance	7%	28%	11.1%
Price	14%	12%	13.6%
Total	50,000 (100%)	12,000(100%)	100%

 

Another alternative in the hands of a differentiated firm is the Skimming policy, that is applying (when possible) different prices to the same product/service according to the customer kind; the highest ones to those customer categories open to spend more and the lowest one to those paying much attention to the money spent on the purchase.

 

How to do it?

 

One way for instance is the different level of potential additional services related to the product/services that could be high for the "rich" and lower for the others.

 

Another way is the different timing of the sale: low prices for the first buyers and higher prices for the following.

 

As you can understand the elements for the best price go beyond the simple cost basis and concern factors depending on the will of the top managenet as well as external factors that affect the pricing and cannot be manoeuvred by the managers such as in some industries the oil price, the interest rates, the seasonality of demand...

The purpose of the dissertation was to highlight the strategic side of the pricing and hope to have been successfull.

Of course some further argumentations are possible and that's why the page Contact can't wait for your "initiatives".

 

 

Throughout this page you have found recurring references to the performance evaluation issues that characterize the life of a business and some distinctions and related dissertations about financial and non-financial metrics have been made.

What happens when the  manager performances have been assessed?

 

Of course, if the targets set previously have been met or overtaken, a bonus, if set, is awarded in the forms and amount agreed upon.

The strategy of the company plays an important role also in this context, even with regard to the choice of the kind of bonus to be awarded.

 

Prior to going in depth some specifications are appropriate to make the importance of the this topic understood in its entirety.

Let's kick off.

 

The kind of metrics used to measure the achievement of the targets, threshold for granting the bonuses, are linked to the nature of the activities of the Business Units if the metrics are non-financial or to the responsibility of the BU if the metrics are financial.

So you can find, with reference to the latter issue, some metrics for costing centers and some others for revenue, profit and investment ones.

All of these two kinds of metrics can also be embedded into a Balanced Scorecard that is even more functional to the achievement of the business strategy.

 

Another aspect I want to consider is the kind of basis to which the metrics chosen are gauged; as a matter of fact the targets can be set either by taking into account the performances of a business unit or those of the company as a whole.

Even in regard to this kind of choice some strategic aspects should be taken into account such as the motivation and the collaboration degree you want to build into a work environment in order to achieve the goals of the business.

Of course the elements that come into play are several and deserve a specific dissertation that isn't the goal of this article.

It goes without saying that the targets taken as a threshold for applying the bonuses should be attributable to the decision-making power of the managers whose performances are being measured and assessed and this is good with reference both for the metrics chosen and the kind of basis.

If you want to know more about the choice of the metrics and basis, the page contacts is the place you can resort to.

 

After hinting at these points, we can focus on the kinds of the bonus a manager can receive and on how they adapt to the horizon of the business goals and how motivating and "goal-congruent" they are.

Let's start with the bonus that are a good fit for the short-term business goals.

 

When a company aims at or needs to aim at a immediate benefit from its projects and I don't argue if it is possible/correct or not, then a cash bonus based on the yearly performances of the BUs involved is the most suitable form of reward.

As a matter of fact, it motivates the managers affected towards the least risky projects causing the business to miss out on sound opportunities resulting from "choices" that are more profitable as a whole although the first periods of lower returns.

It may be the choice of this kind of bonus is made even when the strategy of the Business looks at long term and there isn't awareness of the countereffects in the manager decisions.

This form of bonus can be awarded in a deferred way that is the cash is paid after 2 o 3 years from the reference period.

One of the goals is to cause the good managers to stay with the firm as long as possible.

Of course the advantages and the disadvantages of the deferred bonus are the same as those of the current bonus and at this point both the kinds of bonus might be paid in Stock so that the managers would be both employees and owners of the business and the probabilities of divergent interests between the "parties" decrease.

 

Other goals and other risks are related to the use of the current and deferred bonus and can concern both the manager's sphere and the interests of the business; they can cause even harder conflict to be solved between the goals of the "actors" and the related behaviours than we have seen so far (if you want to see more, page Contacts).

That means the bonus plan should be thought of as in-depth as possible in order to be as "goal-congruent" as possible.

That's why some other forms starting from the late nineties have been intoduced to get the owners' interests and the manager's ones to converge towards the same point.

This point can but be found only as a natural consequence in the long term and the solutions are the Stock Options and the Performance Shares.

 

Why in the long term?

 

Because each of this solution brings advantage if the Shareholder Value increases to a good extent and that happens usually over a long time since it consists not only of an increase in dividends but also of the capital gains related to the Stock Price.

 

Let's start with the Performance Shares.

 

These are shares given by the company to managers and executives only if certain company-wide performance criteria are met and when these consist of  certain levels of the Earning per Share, they make the interests of managers and shareholders more convergent than ever.

Performance shares have a high potential of earnings is but when the uncertainty, not only about the success of the company on the "field" but also on the Stock Market, is great, they are not so motivating.

 

The difference between Performance Shares and the Stock Options is that managers are just an out-an-out Bonus since they receive them as a compensation for meeting targets as opposed to stock options  where employees are awarded of this kind of stock as a part of their usual compensation package.

 

In other terms terms the Stock Options are a potential bonus and are the right stock to purchase at a preset price and at some future date.

This right should be used by the managers just when the Stock Price is higher than the preset one so that they can realize a profit by a following sale.

As a result the managers would put in place their efforts to maximize the Stock Price and their interests would correspond even more to those of the business owners.

The considerations about the uncertainty on the Stock Market made about the Performance Shares are good also in this case.

Some argue that the Stock Options bring about some diadvantages that don't make this compensation a good fit for any context.

I like to mention one of these "flaws": the Excessive Gambling

 

All the holders of the Stock Options care about is being over the Purchase Price, that is they could take excessive risks to go into the positive territory even if there's a huge risk you'll get nailed on the downside.

To make this concept more clear a comparison, an example is needed

 

One manager is given stock at  $ 150, and another manager is given stock options at $ 150. 

They're making up their mind to make a risky investment:

An investment with a 20% chance it will double the value of your company and a 80% chance the value of your company will fall by 30 %.

 

At this point the managers involved will consider the highest expected value.

The expected value of a gamble (in our case the risky investment) is the probability that you earn times the value if you earn plus the probability that you lose times the value if you lose.

When the expected value is greater than zero, then the gamble should be made.

 

"Our" expected value is 0.2 times 100 plus 0.8 times negative 30, that is  an expected value of minus 4%.

 

Based on this formula  if you take this gamble (our investment), and you took it an infinite number of times, you would lose 4% on average. if the decision-making holders took this enough times, they'd lose 4% on average and as a result the shareholder value (through the Stock Price too) would decrease. 

What would the manager who got the $150 in stocks do?

They won't take the gamble and won't take the risky investment since their $ 150 in stock would be worth, on average, 4% less than it would be worth if they take this gamble.

 

Let's consider the manager who got the Stock Options.

He doesn't care how much the value of the company is under his $ 150 worth he has as stock options, he just cares about how much it goes above $ 150.

So what is the calculatione he does?

His calculation is:  - I have a 20% chance of making 100% and a 80% chance of what? 

Zero, ending up with zero. I can't lose. -

In other terms he has a 80% chance of zero because at any level under 150 he won't use his option.

 

So what is his decision? 

He uses the positive 20% gamble. He is going to take any gamble (investment) which has a huge upside because in the worst scenario his situation wouldn't change.

 

Yet the company would have a huge damage from that risky investment in that worst scenario.

 

Here it is how we explained the Excessive Gambling related to the Stock Option plan and how that makes clear once more that the design of a Bonus plan is not so easy to do as one could believe.

 

We have just understood how the choice of the kind of bonus together with the bonus metrics and the bonus basis are issues that should be faced with expertise and knowledge at the top level in order to cause the managers involved to converge to the business goals as much as possibile.

The topic can be dealt with even more in depth and the page Contacts is a way to know more.

 

If you wish you could assess how well your company is using its money, one possible way to calculate to do it is to determine the ROIC (Return On Invest Capital).

Its most used formula is the following:

 

ROIC = (Net Income – Dividends) / Total Capital

 

Let's now look at the numerator, which can be obtained in various ways.

The simplest and most direct one is to subtract the dividends from the net income of the company.

However, we should also consider that for the formation of net income, the company may have taken advantage of some earnings, not related to its core business, that is, of an extraordinary nature, such as some realized capital gains or those derived from the fluctuation of exchange rates in case of sales abroad.

 

In  order to throw off these potential distortions, the so-called NOPAT is also often used; it stands for Net Operating Profit After Taxes.

 

It is calculated by subtracting from the Operating Income the Income taxes (calculated on the "Total" Income ) and the Fiscal benefit of the Financial Expenses (if any).

 

NOPAT = Operating Income -  Income taxes – Fiscal Benefits of Financial Expenses

 

The Operating Income is also defined in some cases as EBIT or Earning Before Interest and Taxes.

 If you want to understand the real difference Operating Income and EBIT, see the article 46 on this webpage.

 

 

Let’s turn to the denominator.

 

The denominator is the sum of all debts and equity. This value can be calculated in various ways.

One method is to add the book value of a company's equity to the book value of its debts, subtracting the non-operating assets.

 Another way to get total capital is to get net working capital, subtracting current liabilities from current assets.

After that, non-liquid net working capital is obtained, subtracting liquidity from the result just obtained.

Finally, non-liquid net working capital is added to the company's operating fixed assets:

Of course the amount to be considered is the average one of the related period and not what you have at the end.

 

 Having said that, we understand how Roic is the ratio between these two measures, each of which can be obtained differently, so it is always expressed in percentage terms and usually on an annual basis.

 

How do you see whether the company is really generating money from its Operating Management?

 

The answer focuses on the creation of value and that’s why you must compare Roic with the Cost of Capital.

If the former is higher than the latter, then the business is creating value, otherwise it is destroying it.

From the difference of these percent terms you can also achieve the EVA (Economic Value Added) by multiplying it by the amount of the Capital, how we explained when writing about the denominator.

 

Roic under control is very important for every company, although for some industries this value is much more significant than for others.

For instance, companies that have put in place a strategy of important investments and want to check them out over their life.

You know very well that some businesses to pursue their strategy, both a Differentiation one and a Price leadership, should make great investments into machinery, equipment and any other factor that enables to achieve a competitive advantage within their reference market according to the value attributes acknowlegded by their customers.

In other terms those companies are capital-intensive and need some effective metrics to look over the return of these investments.

Roic is very important to this purpose.

 

The best way to put it under control is to check its trend out over the life of the firm (better if together with EVA); as a matter of fact, there isn't a strict reference value of this metric and that's why looking at how it goes along over the time is very appropriate and if compared to the competitors it is more significant.

 

Having said that, I would add that it could be used even better together with other indicators, in order to better assess the state of the company.

For example, I would suggest the creation of an indicator that takes into account the capacity of the company to manage the liquidity whose issues can in their turn affect the operations themselves of the business.

In this regard I proposed in the article 5 the GSI (Global Succes Indicator) considering both the Profitability aspect and the Cash management aspect.

 

On the other end if you want to take into account other value than the accounting-based ones, you could see Roic, GSI and the P/E ratio, i.e. the ratio of the share price to earnings.

When this is high, it would tend to suggest that the company on the stock exchange would be overvalued, but it could also signal a high return on invested capital, that means the shares are premium-quoting, compared to those of other competitors.

 

In other terms this would confirm once more that you have a real competitive advantage since, compared to your rivals, you operate at a higher return and  command a premium price.

 

Many businesses set as main operating profitability measures those linked to the accounting records and even more limited to the short term; that is they don't go beyond the single fiscal period.

If on one side they are easy to be determined, on the other they don't reflect some of the main features a single profitability measure should have in my view and neglect some potential negative behavioural effects.

These features concern for instance goal congruency, motivation, fairness and all of them are referred to the managers that are in charge of the business units.

 

In this article I am going to deal with some of the main accounting-based measures in place with regard to the investments centers where the respective managers are responsible not only for the revenue levers and current costs but also make investment decisions.

Some considerations will be made about the ways one can adopt in order to enhance their informative value and compensate for their flaws.

All of them with an eye at the strategy of both the business unit and the whole group a BU is part of.

 

Let's get started.

 

What is the most common ratio used on Operating profitability measurement purposes?

 

Without a doubt ROI, that is Return on Investment.

 

ROI = Profit/Investment

 

Prior to disserting on this in a strategic slant, some clarifications should be made in order to make the following article as precise as possible and as realistic as we can.

 As you may know it is an accounting-based measure and there are two ways the Finance Managers usually adopt to define both the numerator and the denominator of this formula.

The most used one sees the Operating Income at the numerator and the Total Assets at the denominator: Operating Income/Total Assets.

 

The other is EBIT/Total Assets.

 

Many times these ratios are considered as interchangeable but in some cases they aren't the same thing and have a different meaning.

An example accompanied with an Income Statement will be useful to our purposes.

 

In the table 1 we guess that the company Alfa Inc. doesn't hold any non-operating assets; in this case EBIT and Operating Income will have the same amount

 

Table 1 - Income Statement of Alfa Inc.

  

Revenues	20,000,000 -
Cost of Goods Sold	12,000,000 =
Gross Profit	8,000,000 -
Sales & Mark.	2,000,000 -
Admin.	1,000,000 -
R&D	1,500,000 =
Operating Income/EBIT	3,500,000 -
Interests	250,000 =
Pre-Tax Income	3,250,000 -
Taxes	975,000 =
Net Income	2,275,000

 

In this case both of these ratios have the same amount and will be good at assessing the operating profitability of the Business Unit, that is understanding how good the respective managers were able to put their assets to work.

It goes without saying that in the budget period both of them are also good at setting the operating profitability targets; the extent to which the same managers should be able to put their assets to work in the next period.

 

Let's suppose that the company holds some gold stock, some forward contracts to hedge its exposure to oil or foreign currency or something else.

 

This is just an example that highlights how the company or some of its Business units might hold some non-operating assets that are able to generate investment income.

Turning back to our example, let's guess that the amount those investments yield for Alfa Inc. adds up $ 300,000.

Here is the new Income Statement.

 

Table 2 - Income Statement of Alfa Inc. with Investment Income

 

Revenues	20,000,000 -
Cost of Goods Sold	12,000,000 =
Gross Profit	8,000,000 -
Sales & Mark.	2,000,000 -
Admin.	1,000,000 -
R&D	1,500,000 =
Operating Income	3,500,000 +
Invest. Income	300,000 =
EBIT	3,800,000 -
Interests	250,000 =
Pre-Tax Income	3,550,000 -
Taxes	1,065,000 =
Net Income	2,485,000

 

In this case the Operating Income will be the numerator of the ROI while EBIT should be ignored as a numerator of a ratio that serves as a measure of the operating profitability of the Business Unit.

Of course when one should consider EBIT to see how much one takes out of all its assets, the denominator should include the non-operating assets, too.

 

After removing all doubt about a common misunderstanding of the financial analysts of a company, I will deal with some strategic implications following the use of ROI in the manager performance assessment and in issues related to it.

 

I specify "some" since the implications are multiple and require further "dives" into the reality of the BUs involved and procedures concerned.

 

As of now the dissertation will go along by highlighting some points of this metric related either to its short-term essence or to a peculiar situation of the organization using it; all of them affecting some issues such as motivation, goal congruency and fairness.

At the end the dissertation will focus on some general aspects of its use with regard to the same issues.

 

 

1. Short-term limitation

 

a) Fairness

 

ROI like all the accounting-based measures has a short-term horizon and and when some changes happened recently in the management policy, last but not least change in people with decision-making power, it doesn't help at all assess the direction of the new managers.

As you know the profit you find at the numerator is the result also of the investments made in the previous years when the management and the strategy of the business unit could be different from the present ones.

That means that evaluating the "behaviour" of the manager presently in charge on that basis is not fair enough.

 

How can you compensate for these "flaws"?

 

A potential remedy could be the use of a scorecard the may include the "scores" achieved in the latest fiscal period with reference to some non-financial indicators linked to the objectives of the BU (here is where the Balanced Scorecard fits in with better than any other kind of scorecard).

 

A possible adjustment that concerns only ROI provides the comparison of the latest value to  its average over a largest period and as a result one is able to make all the related considerations.

 

b) Goal Congruency

 

You know very well the most used methods to evaluate a project take into account the discounted cash flows generated by the long-lived assets.

One of them is without a doubt the NPV (Net present value) that considers as a good investment the project that gives after all its duration a positive total after-tax cash flow.

Very often at the beginning of the life of the project the results are not positive in a sense that the cash outflows overtake the cash inflows.

This peculiarity affects the ROIs of the first periods of the tbusiness unit involved by that investment so that the respective managers conflict with the CFOs that in their turn do just their job.

The ways to allign the "points of view" exist and involve some "accounting" adjustments to be made to the assets affected by the project.

If you would like to go in depth, you can write on page Contacts of this website.

  

 

2. Multiple Investment Centers within a company

 

a) Fairness 

 

This element comes into play also when multiple Investment centers exist within a company and/or a group and the respective managers are evaluated according to the ROI "scores".

Each of the BUs involved has their own equipment, machinery and other depreciable assets with their own age.

It's clear enough that the owners of the oldest assets, that do their job very well despite their age, take advantage when the Net Book Value is used for the assets included into the denominator of the ratio being consisdered as ROI, Operating income/Assets.

On the opposite side we find the managers of the BUs that hold the newest assets; it will be them to have the highest denominator and as a result the lowest ROI.

At this point in order to have a correct profitability measure, at the same time fairer and more adherent to the financial measurement needs of the company, it would be appropriate replacing the NBV with another value that could be either the replacement cost or other costs taking into account the current value of the assets and, why not, the specific situation of the BUs involved.

 

Further fairness issues may arise when the BUs have different risk situation and some adjustments should be made. Also for these details you can write on page Contacts.

 

b) Goal congruency

 

When the managers are assessed on the basis of ROI some conflicts can arise between them and top management.

For instance that happens when top management endorses some investments that affect in a positive way the ROI of the whole company but lowers that of specific BUs.

I will be more clear.

Let's guess that there are many investments centers within a company and that top management is encouraging a shared investment in a sense that impacts the profitability of many BUs.

More precisely this project provides shared assets whose utilization is imputable, according to realistic drivers for the cost allocation, to multiple investment centers.

Prior to accepting and endorsing the new investment, the managers of the BUs with a higher ROI than that of the new investment are likely to oppose it because their profitability score will lower compared to the usual value.

On the other side the BU managers with a lower "single" ROI will encourage the new project.

One of the solutions to bring an end to these conflicts is the Residual Income.

 

 

Box 1 – Residual Income

Another Accounting-based measure of the operating profitability of a Business Unit and in particular of an investment center is the Residual Income. It carries with him many of the considerations that we are doing about ROI but it plays a positive role  with reference to the issue of goal congruency just dealt with in the paragraph “Multiple investment centers within a company”.    First of all, let’s define what is the Residual Income like. It is the difference between the Operating Income and a given reward for the use of the Assets of the BU involved. This reward is achieved by multiplying a percent charge by the value of the Assets considered; this charge usually is the WACC (Weighted Average Cost of capital).   RI = Operating Income – r x Assets    r is WACC   Having Said that, it is clear that a manager is evaluated positively just when this difference is positive as well, meaning that a minimum reward target for the  use of the capital has been achieved since the respective costs has been overtaken by the related earnings.   As a result, turning back to our goal congruency context, all the manageres will accept a new project based on the fact that an additional amount will be achieved (in case of positive Residual Income) following its implementation, neglecting the potential lowering of the Bu’s ROI.

 

 

3. Some general considerations

 

a) Motivation

 

Top Management can decide to take advantage of the use of ROI as a financial performance metric to push the managers of the BUs concerned to go a specific strategic path.

Here is an example.

Let's assume that the company is pursuing a differentiation strategy since its top management's opinion is that will increase the market share and revenues and thanks to this lever and in addition to setting a given budget amount to be spent on the most suitable technological assets it wants to make sure this direction is really executed.

It can capitalize on the denominator of ROI, by using as a criterion the Replacement Cost instead of the Historical value.

As a matter of fact the Replacement Cost is higher than any other criterion and as a result it lowers the ROI of the investment centers concerned and assessed on that basis.

At this point the manager would be more motivated to spent his budget on asset purchase since thank to its work the BU will be able to achieve as well a positive contribution margin that will increase the numerator of ROI by compensating for the amount of denominator, always at the same level even when the purchase isn’t made.

Another example could be made about the incentive from the top management to the BU's managers to use or not to use the idle assets according to the strategic goals.

Page Contacts for further details.

 

Which is another potential limitation of ROI?

 

When this ratio was conceived, the large majority of the industries relied mainly on tangible assets and in fact it's clear how much the physical assets are taken into account in all the considerations we made so far.

Nowadays the situation is different and many industries capitalize on the knowledge of their human capital to make profits more than the tangible assets.

It suffices to consider the web-based companies whose products invaded our life.

 

Please not to confuse this with the Know-How that is related to all the information of any kind achieved by the employees trhoughout the life of the business and that gives it an edge over the competitors.

 

In our case the knowledge of some part of the personnel is the key to making the business successful and as a result it should be considered as an asset to be evaluated and to be put at the denominator of ROI.

Many analysts subtract the annual wage expenses fromthe numerator and add it to the denominator. In other terms they capitalize the gross compensation of the personnel involved.

I don't agree fully to this method since it is just as you for each tangible asset (for instance) put at the denominator neither the historical value nor the current value but its annual depreciation amount. I keep in mind something else that goes beyond the target of this article and won't be shown on this reason.

 

One thing is certain, the discussion over the use of ROI and other accounting-based measures as financial performance metrics has many many aspects that one can make and agree to and that's why this website is going to deal with them in the future publications.