Question

What is meant by classifying a unit as an “investment center” vs. a “cost” or “profit” center? Discuss how each of the following tools, individually and/or collectively, can and should be used to evaluate managers of such “investment center” individual divisions of a large organization: ROI, EVA, and the Balanced Scorecard. (Hint: discuss how each works, what each helps ensure, what dysfunctional behaviors can result from its use, and how multiple approaches can help ensure behavior that aligns individual incentives with overall corporate strategy.)

Answer 1

A) Classification a unit as an "Investment center":- An investment center, also called and investment division, is a way to classify and evaluate a department based on its revenues, costs, and asset investments. Instead of categorizing departments into cost centers and profit centers, management often looks at departments as investment centers.

In other words, it’s a different way of looking at and evaluating how divisions and departments perform.

There are many tools used for evaluate the investment center, for example-ROI, EVA and balanced scorecard

B) How all of above tools help the mangers to evaluate the investment center are as follows:

a) ROI:- ROI has several advantages that may explain its wide use:

1. ROI makes unlikes comparable. Since return is a ratio, it “normalizes” for divisions or companies differing in investment base size. For example, one can meaningfully compare a large steel company’s ROI with a small steel company’s ROI.

2. ROI, being a percentage-return measurement, is consistent with how companies measure the cost of capital. For example, one can say that a company with an 8% ROI (before capital costs) is faring poorly if its cost of capital is 10%.

3. ROI is useful for people outside the company. The ROI measure, unlike residual income, can be calculated by outside financial analysts for purposes of evaluating the economic performance of a company and for making inter company performance comparisons. Many top executives thus want their division managers to focus on ROI performance, since outsiders (especially potential investors and their advisers) are focusing on it.

In my opinion, however, ROI has potential drawbacks as a measure of an investment center’s performance. Two of these are:

1. The same decisions that increase a center’s ROI may decrease its economic wealth. For example, in an investment center whose current ROI is 25%, its overall ROI can be increased by dis-investing in an asset whose ROI is 20%; yet, if the cost of invested funds is less than 20%, the absolute amount of the investment center’s profit after taking account of capital costs will decrease.

2. Given an investment opportunity whose ROI is above the cost of capital but below an investment center’s current ROI, the center’s manager may forgo this opportunity, since the investment, while economically sound, will lower the center’s ROI below the current level.

b) EVA Tools:  Economic value added (EVA) is a measure of a company's financial performance based on the residual wealth calculated by deducting its cost of capital from its operating profit, adjusted for taxes on a cash basis. EVA can also be referred to as economic profit, as it attempts to capture the true economic profit of a company. This measure was devised by management consulting firm Stern Value Management, originally incorporated as Stern Stewart & Co.

Reasons for Implementing EVA:

1) EVA as a complete measure of performance

2) Addressing the problems that are associated with the decentralized organisation

3) Economic dependence

c) Balanced Scorecard:- A balanced scorecard is a performance metric used in strategic management to identify and improve various internal functions of a business and their resulting external outcomes. It is used to measure and provide feedback to organizations. Data collection is crucial to providing quantitative results, as the information gathered is interpreted by managers and executives, and used to make better decisions for the organization.

Reasons for Implementing Balanced Scorecard:

The balanced scorecard is used to reinforce good behavior in an organization by isolating four separate areas that need to be analyzed. These four areas, also called legs, involve learning and growth, business processes, customers, and finance.

The balanced scorecard is used to attain objectives, measurements, initiatives, and goals that result from these four primary functions of a business. Companies can easily identify factors hindering business performance and outline strategic changes tracked by future scorecards.

The balanced scorecard can provide information about the company as a whole when viewing company objectives. An organization may use the balanced scorecard to implement strategy mapping to see where value is added within an organization. A company also utilizes a balanced scorecard to develop strategic initiatives and strategic objectives.