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Nbv Property Management – Question: Perhaps the most common performance metric for managers responsible for investment centers is return on investment (ROI).
Note that different organizations use different metrics to calculate ROI. Our goal in this discussion is to introduce a common approach, but keep in mind that organizations often make adjustments to this formula to better suit their needs.
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The advantage of ROI as a performance metric is that it includes asset utilization. For example, suppose 2 divisions have $10,000 in operating profit. Both divisions appear to have performed equally well on an operating profit basis. However, a closer look shows that Division 1 invested $200,000 in average operating assets to produce this income while Division 2 invested $400,000. Obviously, the division that invested half the amount in assets to produce the same amount of income had the better performance of the two. The comparison of the ROI of each division proves it:
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Answer: Operating profitRevenue generated by the division related to its day-to-day activities; it generally excludes items such as income tax expense, interest income, interest expense, and unusual gains or losses. is the income produced by the division of its day-to-day activities. This
Items used in the calculation of net income, such as income tax expense, interest income, interest expense and any unusual gains or losses. The focus is on the division’s performance against its core business activities, which does not include one-time gains or losses from the sale of property, plant and equipment, for example.
Answer: Average Operating AssetsAssets the division has to manage the day-to-day operations of the business; it is calculated using operating asset information as follows: (Beginning Period Balances + Ending Period Balances) ÷ 2. are the assets the division has in place to manage operations daily business, and this value is calculated by adding the beginning period balances and the ending period balances and dividing by two. Examples of operating assets include cash, accounts receivable, prepaid assets, buildings and equipment. As long as the division uses the assets to produce operating income, they are included in the operating asset category. Examples of non-operating assets (assets not included in this calculation) include land held for investment purposes and office buildings leased to other companies.
Operating assets are averaged over the period assessed for two reasons. First, operating assets are often bought and sold during an accounting period, and simply taking the ending balance can produce skewed or even inaccurate results. Second, operating income represents information over a given period (income statements always present information over a period
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), while operating assets are presented at a given time (balance sheets always present information for a
). If both of these items are to be included in a ratio (ROI), it is best to use the average balance information for balance sheet items. In fact, if the information is readily available, it would be best to take an average of the daily balances of operating assets for the period being assessed.
Answer: Figure 11.3 “Segmented Income Statements (Game Products, Inc.)” presents segmented income statement information for each of Game Products’ three divisions. The
Line of this income statement provides the information needed for the numerator of the return on investment calculation. Figure 11.4 “Segmented Balance Sheets (Game Products, Inc.)” shows the segmented balance sheets for each division needed to calculate
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Let’s see how each division ranks using ROI. Assume that all assets of Game Products, Inc. are operating assets. We use the information from Figure 11.3 “Segment Income Statements (Game Products, Inc.)” and Figure 11.4 “Segment Balance Sheets (Game Products, Inc.)” to calculate the return on investment for each division in Figure 11.5 “Return on Investment Calculations (Game Products, Inc.), Inc.)”.
*The operating income figure is taken from the segmented income statements shown in Figure 11.3 “Segmented Income Statements (Game Products, Inc.)”.
** Average operating assets are calculated using balance sheet information in Figure 11.4 “Segment Balance Sheets (Game Products, Inc.)”. Since all Game Products, Inc. assets are operating assets, total asset amounts are used in this calculation. The calculation of the average operating assets for each division is (initial balance of total assets + ending balance of total assets) ÷ 2. The Sporting Goods division’s average operating assets are $29,350 (= [$30,500 + $28,200] ÷ 2).
The ROI metrics presented in Figure 11.5 “ROI Calculations (Game Products, Inc.)” show that although the Board Games division has the highest operating revenue, its ROI falls in the middle of the three divisions. The Sporting Goods division has the highest ROI at 11.23%, board games are second at 8.93%, and computer games are the lowest at 6.75%. Since managers in each division are responsible for maximizing profits based on the investments they make in assets, return on investment is a reasonable approach to evaluating each manager. The Sporting Goods Division Manager appears to perform better than the other two managers on this measure.
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Like most financial measures of performance, ROI can be calculated in several different ways. The components of this calculation often vary from organization to organization. These variations are discussed next.
Question: For purposes of the Game Products, Inc. example, we use the same definition of operating income that we use for financial reporting purposes under US GAAP. However, organizations often create their own unique calculation of operating profit for internal valuation purposes.
Answer: There are several variations that organizations use to calculate operating profit. Two of the most common variants are discussed below.
Game Products, Inc.’s segment income statements are shown again in Figure 11.6 “Segment Income Statements (Game Products, Inc.)” (these are the same segment income statements as in Figure 11.3 (Game Products, Inc.) .)”). Notice the expense line labeled
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. Although we include this expense in the calculation of operating profit, many organizations do not, particularly if division managers have no control over allocated overhead. Excluding allocated overhead has the effect of increasing each division manager’s return on investment and holds each division manager accountable only for controllable amounts of expenses.
. Although we do not include income tax expense in the calculation of operating profit, some organizations prefer to include this item. Including after-tax expenses reduces the return on investment for each division manager (assuming each division is profitable).
The point here is that management needs determine how to define operating income. Unless otherwise specified, we will use the US GAAP definition shown as operating income in Figure 11.6 “Segment Income Statements (Game Products, Inc.)” throughout this chapter.
Question: For Game Products, Inc., we assume all assets are operating assets. In other words, all assets are used in the day-to-day operations of the business. As noted earlier, assets that are not used in day-to-day business operations, such as land held for investment purposes or buildings subleased to other companies, are not included in this calculation. . The average is found by taking the starting balance plus the ending balance and dividing by two. The problem in this calculation focuses on long-lived assets that are depreciated over time.
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Answer: There are two common approaches to valuing long-lived assets when calculating return on investment. Each approach is discussed next.
In the Game Products, Inc. example, we use the net book value of long-lived assets to calculate operating assets. That is, the accumulated depreciation is subtracted from the original cost in the segment balance sheet in accordance with US GAAP. The balance sheet shown in Figure 11.4 “Segmented Balance Sheets (Game Products, Inc.)” shows this in the row labeled
. The advantage of using net book value is that the information is easily obtained from financial records.
The problem with this approach is that division managers with older assets that have been significantly depreciated have an advantage over division managers with newer assets that have not been significantly depreciated. Older assets have a lower net book value (cost – accumulated depreciation) than newer assets, reducing average operating assets in the denominator and increasing return on investment.
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For example, suppose two divisions have identical operating revenues for the year and identical assets. However, Division 1 has been in operation for many more years than Division 2 and has therefore accumulated much more depreciation on long-lived assets. This results in a lower net book value on long-lived assets for Division 1, as shown below:
Assuming all other assets are the same and both divisions have identical operating profit, Division 1 will have a higher return on investment simply because the long-lived assets are older and have more accumulated depreciation , thereby reducing average operating assets in the denominator. (Reducing the denominator increases the ratio.)
An additional weakness in using net book value to calculate average operating assets is the disincentive it creates for division managers to replace old and inefficient long-lived assets, such as equipment and machinery. Although the purchase of new equipment may be necessary to improve efficiency and remain competitive, the short-term impact is to reduce the return on investment. (Older equipment will have a lower net book value than identical newer equipment, so replacing old equipment will reduce the return on investment.)
If division managers are evaluated on the basis of return on investment, the use of net book value tends to discourage investment in long-lived assets, often at the expense of the organization’s long-term profitability.
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An alternative approach in the calculation
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