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Use of the rate of return on investment in the evaluation of performance of a business and its executive. Gorelik, George 1960

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USE OF THE RATE OF RETURN ON INVESTMENT IN THE EVALUATION OF PERFORMANCE OF A 'BUSINESS AND ITS EXECUTIVE by GEORGE GORELIK B. Com., U n i v e r s i t y of London (England), 1954 A THESIS SUBMITTED IN PARTIAL FULFILMENT OF THE REQUIREMENTS FOR THE DEGREE OF MASTER OF BUSINESS ADMINISTRATION i n the F a c u l t y of , Commerce and Business A d m i n i s t r a t i o n ' We accept t h i s t h e s i s as conforming to the r e q u i r e d standards THE UNIVERSITY OF.BRITISH COLUMBIA " A p r i l , I960. In presenting this thesis in p a r t i a l fulfilment of the requirements for an advanced degree at the University of B r i t i s h Columbia, I agree that the Library shall make i t freely available for reference and study. I. further agree that permission for extensive copying of this thesis for scholarly purposes may be granted by the Head of my Department or by his representatives. It is understood that copying or publication of this thesis for financial . gain sh a l l not be allowed without my written permission. Faculty of Commerce and Business Administration The University of B r i t i s h Columbia, Vancouver 8, Canada. Date A p r i l . I960.  ABSTRACT T h i s paper i s concerned w i t h the use of the r a t e of r e t u r n on investment i n e v a l u a t i n g the e f f e c t i v e n e s s w i t h which the e n t e r p r i s e a s s e t s a r e used by both d i v i s i o n a l and top management.. I n l a r g e d e c e n t r a l i z e d companies t h e r e i s a d i f f u s i o n o f p r o f i t r e s p o n s i b i l i t y and t h e r e i s a need f o r a common measure to e v a l u a t e the o p e r a t i n g r e s u l t s of u n i t s o f a. b u s i n e s s and the company as a whole, as w e l l as to e v a l u a t e the performance of d i v i s i o n and top management. , The r a t e of r e t u r n on investment r a t i o . w a s i n v e s t i g a t e d i n terms o f i t s components: s a l e s , income, and investment. S i n c e the unique c h a r a c t e r i s t i c o f the r a t e of r e t u r n measure i s the i n c l u s i o n of investment, d e f i n i t i o n and c o n t r o l over investment were found to.be o v e r r i d i n g f a c t o r s . The c o n c l u s i o n o f t h i s paper i s t h a t the r e t u r n on investment i s one of the methods t h a t can be used i n measuring and e v a l u a t i n g performance. Qh the assumption t h a t p r i m a r y g o a l o f b u s i n e s s i s p r o f i t , the d i s c u s s i o n then d e s c r i b e s c e r t a i n c o n d i t i o n s under which the r a t e of r e t u r n on investment w i l l e f f e c t i v e l y measure performance of a company and i t s d i v i s i o n s . i v TABLE OP.CONTENTS CHAPTER PAGE I . THE PROBLEM, DEFINITIONS.OP TERMS -USED -AND QUESTIONS ASKED . , , 1 I n t r o d u c t i o n . ' • 1 The Problem . . . . . . . . . . . . . . . . . 1 Statement of the Problem. . . . . . . . . . . 1 Importance of the Study . . . . . . . . . . . 2 Scope of the Study. < . . 3 Research Method 4 D e f i n i t i o n s of Terms Used 4 Operating- E f f e c t i v e n e s s . . . . . . . . . . . 4 D i v i s i o n . . » . 4 C o n t r i b u t i o n P r o f i t s 4 Investment and Income . . . . . . 5 Questions Asked . . . 5 I I . HISTORICAL BACKGROUND . . . . . . . . . 8 I I I . BASIC THEORY OP RATE OF RETURN.ON INVESTMENT. . . 13 General.Considerations . . . 13 Ba s i c Formula:.-. . . . ; 13 Turnover and Sales Margin A n a l y s i s 15 S i g n i f i c a n c e of the Rate of Return.on Investment Measure 18 IV. OBJECTIVES AND CONDITIONS FOR EFFECTIVE PERFORMANCE MEASUREMENT AND., EVALUATION. . . . . . 21 Ob j e c t i v e s of Performance Measurement , 21 v CHAPTER PAGE 21 Statement of O b j e c t i v e s . Fact o r s o u t s i d e Managerial C o n t r o l 23 C o n f l i c t of O b j e c t i v e s • • • 24 Con d i t i o n s f o r E f f e c t i v e Performance Measurement and E v a l u a t i o n i n Terms of Rate of .Return, on Investment . 24 Company L e v e l 25 D i v i s i o n L e v e l 26 V. PROBLEMS OF INCOME DEFINITION 29 General Background. . . 29 Income D e f i n i t i o n f o r Inter-Company .. Comparisons 35 Dividend Income, I n t e r e s t Income.. and Other Income. 36 I n t e r e s t Expense, Income Taxes, and Other Expense 37 D e p r e c i a t i o n Expense 39 C o n c l u s i o n . . . . . . . 46 D e f i n i t i o n s of Income f o r Intra-Company Comparisons . . . . . . . 41 VI . PROBLEMS OF INVESTMENT DEFINITION 44 D e f i n i n g Investment f o r Inter-Company Comparisons . . . . . . 44 D e f i n i n g the Investment Charged to D i v i s i o n s 48 A l l o c a t i o n of Assets to D i v i s i o n s 52 F i x e d Assets . . . . . . . 54 v i CHAPTER PAGE Background . . 54 Choice of Gross or Net P i x e d Assets 57 Inter-Company and Intra-Company Comparisons . 59 Current Rate of Return 61 R e f l e c t i o n of Performance Changes i n the Rate of Return on Investment 65 E f f e c t of Gross or Net"Assets on.Rate of Return on Investment . $6 C o n c l u s i o n s . 68 V I I . USES OP THE RATE OP RETURN ON INVESTMENT . . . . 70 Improvement i n Performance Through Use of Rate of Return on Investment . . . . . . . . . 71 Problems i n E v a l u a t i n g the Rate of Return on Investment . . . . . . . . . . . . 75 Performance A p p r a i s a l of a Company . . . . . . . 78 H i s t o r i c a l Comparison of Performance - 79 Comparison w i t h Competition 80 Comparison w i t h Well-Managed Companies . . . . 81 A p p r a i s a l of D i v i s i o n a l Performance 83 V I I I . SPECIAL PROBLEMS OP THE RATE OP. RETURN ON INVESTMENT . . . . . . . . . . . . . . . . . . . 85 Establishment of T r a n s f e r P r i c e s . . . . . . . 85 General Background . . . 85 Negotiated T r a n s f e r P r i c e s . 86 T r a n s f e r s at Cost 87 T r a n s f e r s at Cost p l u s a Return on Investment ' 88 v i i CHAPTER PAGE Tra n s f e r s @,t .Market P r i c e s . . . . . . . . . . 89 Conclusions . . ; 89 L e a s i n g of F a c i l i t i e s 90 Investment D e c i s i o n s at D i v i s i o n L e v e l . . . . . 91 L i m i t a t i o n s of the Rate of Return on Investment i n Evaluating- Performance. . . . . 92 IX. CONCLUSIONS OP THE STUDY. 95 BIBLIOGRAPHY . 98 APPENDIX. . . . V . . 105 v i i i L I S T OP TABLES TABLE PAGE I . R e t u r n o n I n v e s t m e n t , 13 I I . A n a l y s i s o f R e t u r n o n I n v e s t m e n t 15 I I I . C o m p a r i s o n o f R a t e o f R e t u r n o n G r o s s A s s e t s w i t h R a t e o f R e t u r n o n N e t A s s e t s 67 I V . R e t u r n o n I n v e s t m e n t o f " X " Company f r o m . 1953 t o 1958 79 V . C o m p a r i s o n w i t h C o m p e t i t i o n 80 V I . A n a l y s i s o f t h e R a t e o f R e t u r n o f C h o s e n . Companies i n t h e Same I n d u s t r y 81 V I I . C o m p a r i s o n w i t h W e l l - M a n a g e d Companies 82 V I I I . R a t e o f R e t u r n A n a l y s i s C a n a d i a n O i l Companies L i m i t e d . . ; . . 110 I X . R a t e o f R e t u r n A n a l y s i s T e x a c o Canada L i m i t e d . I l l X . R a t e o f R e t u r n A n a l y s i s B r i t i s h A m e r i c a n O i l Company L i m i t e d 112 X I . R a t e o f R e t u r n A n a l y s i s - . . I n t e r - C o m p a n y C o m p a r i s o n o f R a t e o f R e t u r n o n I n v e s t m e n t f o r 1958 . . . . . . . 113 i x LIST OF TABLES TABLE , PAGE X I I . Rate of Return A n a l y s i s A b i t i b i Power and Paper Company L i m i t e d . 117 X I I I . Rate of R e t u r n A n a l y s i s St Lawrence C o r p o r a t i o n . L i m i t e d 118 XIV. Rate of R e t u r n A n a l y s i s Anglo-Canadian P u l p and Paper M i l l s L i m i t e d . •-. 119 XV. Rate of R e t u r n A n a l y s i s Inter-Company Comparison of R a t e s . o f Return.on Investment! . f o r 1958 . . . . . . . . . . . . . . 120 1 CHAPTER 1 THE PROBLEM, •DEFINITIONS OP TERMS USED, AND "QUESTIONS ASKED I INTRODUCTION There i s no one h a s i s of e v a l u a t i n g managerial performance. The many v a r i a b l e f a c t o r s i n v o l v e d i n the s u c c e s s f u l management of business e n t e r p r i s e are not e a s i l y r e s o l v e d i n t o a s i n g l e t o t a l i m p r e s s i o n , nor indeed can any s i n g l e y a r d s t i c k or standard p r o p e r l y measure any s p e c i f i c p e r i o d of operations without some a d a p t a t i o n to the s p e c i f i c f a c t o r s i n v o l v e d . E f f e c t i v e management i s the composite of many f a c t o r s and each of them must be measured and a p p r a i s e d d i f f e r e n t l y . However,. management does need a common measure to evaluate the o p e r a t i n g r e s u l t s of u n i t s of a business and to compare one business r e s u l t s w i t h those of other b u s i n e s s e s . The management a l s o needs an o b j e c t i v e measure a f an i n d i v i d u a l e x e c u t i v e ' s performance. I I THE PROBLEM Statement of the problem. I t was the purpose of t h i s study ( I ) to examine c r i t i c a l l y the r a t e of r e t u r n on investment as a method of e v a l u a t i n g the e f f e c t i v e n e s s w i t h which the e n t e r p r i s e a s s e t s are used by both d i v i s i o n a l and top management; (2) to de f i n e o b j e c t i v e s f o r and to . measure the a c t u a l o p e r a t i n g r e s u l t s of d i v i s i o n s and companies;'and (3) to p o i n t out the elements i n a business s i t u a t i o n which w i l l be f a v o u r a b l e and unfavourable t o the e f f e c t i v e use of the r e t u r n on investment as a guide to both d i v i s i o n a l and top management. Importance of the study. Present-day r e s e a r c h has de f i n e d at l e a s t e i g h t s i g n i f i c a n t f a c t o r s measuring b u s i -ness performance: 1 . P r o f i t a b i l i t y 2. Market p o s i t i o n 3. Product l e a d e r s h i p 4. P r o d u c t i v i t y ( e f f e c t i v e use of c a p i t a l , men, m a t e r i a l s ) 5. P e r s o n n e l development 6. P u b l i c r e s p o n s i b i l i t y 7. Employee a t t i t u d e s 8. Balance between l o n g and short-term g o a l s . 1 A f t e r r e f l e c t i n g on each of these c r i t e r i a , the i n e v i t a b l e c o n c l u s i o n i s th a t a l l f a c t o r s must u l t i m a t e l y pay o f f i n p r o f i t a b i l i t y , otherwise being number one w i t h i n an i n d u s t r y i n product l e a d e r s h i p , market p o s i t i o n , e t c . , would make l i t t l e sense. This i s based on the assumption th a t p r o f i t i s s t i l l the primary o b j e c t i v e of business a c t i v i t y and th a t the u l t i m a t e g o a l of management, remains the long-term maximization of p r o f i t . A p e r f e c t y a r d s t i c k which measures q u a n t i t a t i v e l y management's performance w i l l p robably never be found. The q u a l i t y of"judgment, i n a p p r a i s i n g a l l c o n t r i b u t i n g f a c t o r s to business r e s u l t s w i l l continue to be an a l l - s i g n i f i c a n t _ _ Harvey 0. Edson, "Return on Investment (ROI) As a•Measurement.of Management E f f i c i e n c y , " .The C o n t r o l l e r June, 1957, p. 271. 3 c o n t r i b u t i o n of top management. Despite i t s obvious l i m i t a t i o n s and.notwithstanding the f o r e g o i n g , the r e t u r n on investment i s considered to be the best common measure of managerial e f f e c t i v e n e s s developed thus f a r . Scope of the study. This paper concerns companies i n g e n e r a l and a l s o d e c e n t r a l i z e d companies i n which, at l e a s t f o r accounting purposes, the companies are d i v i d e d i n t o u n i t s to which revenues, expenses, and i n v e s t -ment are a t t r i b u t e d . Although the r a t e of r e t u r n on investment can be used by i n v e s t o r s i n t h e i r a p p r a i s a l of company performance, t h i s study takes the view of the i n t e r n a l management and i n v e s t i g a t e s the e f f e c t i v e n e s s w i t h which t o t a l e n t e r p r i s e a s s e t s are u t i l i z e d . The r a t e of r e t u r n on investment can a l s o be used to appraise the method of f i n a n c i n g business o p e r a t i o n s . This i s u s u a l l y the r e s p o n s i b i l i t y of top management, and any managerial e v a l u a t i o n should take i t i n t o account. Because of time l i m i t a t i o n s , however, the problem of f i n a n c i a l e v a l u a t i o n w i l l not be t r e a t e d i n d e t a i l . Two other s u b j e c t s have an important bearing- on the use of r e t u r n on investment to measure d i v i s i o n a l and o v e r a l l performance, v i z . , the f u n c t i o n s of the c a p i t a l budgeting and the p r i c i n g of t r a n s f e r s between d i v i s i o n s , the l a t t e r a p p l i c a b l e s t r i c t l y to d i v i s i o n s . Some suggestions will.be.made f o r a sound system of intra-company t r a n s f e r p r i c i n g , . C a p i t a l budgeting-, although i t cannot be avoided completely i n a study of the use of r a t e of r e t u r n on i n v e s t -ment f o r measurement and e v a l u a t i o n purposes, w i l l not, because of time l i m i t a t i o n s , be t r e a t e d i n d e t a i l , i n t h i s s t u d y . Research method. E x t e n s i v e r e v i e w of the c u r r e n t l i t e r a t u r e on the r a t e of r e t u r n on investment and r e l a t e d t o p i c s was undertaken and c o n c l u s i o n s were drawn t h e r e f r o m . The r a t e of r e t u r n concept was f i n a l l y a p p l i e d to a number of f i n a n c i a l statements of s e v e r a l companies w i t h i n two Canadian i n d u s t r i e s i n o r d e r to compare the o v e r a l l perform' ance of a company w i t h . t h a t o f . o t h e r companies i n the same i n d u s t r y . ( S e e appendix, page 105.) I l l DEFINITIONS OP TERMS USED Operating' e f f e c t i v e n e s s . By o p e r a t i n g e f f e c t i v e -ness i s meant the e f f e c t i v e n e s s w i t h which both top and d i v i s i o n a l management have used the a s s e t s e n t r u s t e d to them. The e f f e c t i v e n e s s w i l l show i t s e l f i n a p r o f i t f i g u r e or i n the attainment of o t h e r s t a t e d sompany o b j e c t -i v e s . D i v i s i o n . When both p r o f i t s and investments are a t t r i b u t e d to the u n i t s , they w i l l be c a l l e d h e r e a f t e r " d i v i s i o n s " or " p r o f i t - i n v e s t m e n t - c e n t e r s " to d i s t i n g u i s h them from " p r o f i t - c e n t e r s " to which o n l y p r o f i t s are a t t r i b u t e d . The d i v i s i o n a l manager w i l l be r e s p o n s i b l e f o r the f u n c t i o n a l o p e r a t i o n s of the d i v i s i o n , i . e . , the p r o d u c t i o n , p u r c h a s i n g , engineering-, s a l e s , e t c . C o n t r i b u t i o n p r o f i t s . C o n t r i b u t i o n p r o f i t s are those p r o f i t s which a r i s e out of matching- of c o s t s and 5 revenues over which the d i v i s i o n a l manager has c o n t r o l . Investment and income. Investment c o n s i s t s of items on the asset s i d e of the c o n v e n t i o n a l balance sheet. Income i s g e n e r a l l y a net income f i g u r e f o r the p e r i o d computed under the c l e a n s u r p l u s theory assumptions. I t i s net of d e p r e c i a t i o n expenses, hut before the i n t e r e s t on funded debt and the income t a x e s . Problems of investment and income d e f i n i t i o n s w i l l be c o n s i d e r e d i n d e t a i l i n subsequent c h a p t e r s . IV QUESTIONS ASKED . How good i s the r a t e of r e t u r n on investment i n evaluating - company and d i v i s i o n a l performance w i l l depend on how c l o s e l y i t approaches the i d e a l y a r d s t i c k which takes a l l the f a c t o r s a f f e c t i n g o p e r a t i n g performance i n t o account and s p o t l i g h t s the areas of good and bad performance. A well-made measurement system can help management to see c l e a r l y the f i n a n c i a l aspects of what the company and d i v i s i o n s are l i k e , what they have done and what they are doing. I t can a l s o h elp the management to a r r i v e at t h e i r own e v a l u a t i o n s . The v a l i d i t y of the r a t e of r e t u r n on investment i n the e v a l u a t i o n of performance w i l l be brought out then by the following- questions :: 1. Does the r a t e of r e t u r n on investment i d e n t i f y good and bad performance and p o i n t to where performance can be improved? 2. Does the r a t e of r e t u r n on investment measure r e f l e c t the e f f e c t of a l l f a c t o r s r e q u i r e d f o r s u c c e s s f u l o p e r a t i o n ? 3. Does the use of the r a t e of r e t u r n on investment l e a d to any b e t t e r performance ? An a f f i r m a t i v e answer to these questions has c e r t a i n l y been, i m p l i e d i n most of the p u b l i s h e d writing's on the s u b j e c t . Nobody, however, has as yet demonstrated t h a t h i g h p r o f i t a b i l i t y and success are a d i r e c t r e s u l t of the use of r a t e of r e t u r n on investment to measure performance indeed, i t i s d i f f i c u l t to do so. N e v e r t h e l e s s , i t may be p o s s i b l e through examination of a number of s i t u a t i o n s to form some v a l i d o p i n i o n as to whether t h i s presumption stands up. The- answers to these questions w i l l be sought i n the a n a l y s i s of the r a t e of r e t u r n on investment formula and i n the c o n s i d e r a t i o n of f a c t o r s i n business environment which favour the e f f e c t i v e use of the r a t e of r e t u r n on investment to measure and evaluate performance. A number of these f a c t o r s may be the r e s u l t of top management p o l i c y and a c t i o n ; others may be determined by c e r t a i n c h a r a c t e r i s t i c s of a business s i t u a t i o n which are not c o n t r o l l a b l e by anyone i n the company. Mana g e r i a l judgment w i l l be b e t t e r and e v a l u a t i o n of d i v i s i o n a l and company performance i n terms of the r a t e of r e t u r n on investment sounder, i f the l i m i t a t i o n s are known and the s i g n i f i c a n c e of these v a r i o u s f a c t o r s i s p o i n t e d out and understood. Attempt w i l l be made to devise c e r t a i n business c o n d i t i o n s , under which the r a t e of r e t u r n .on investment w i l l be most e f f e c t i v e i n measuring d i v i s i o n a l performanc Management should r e c o g n i z e , however, t h a t i n e v a l u a t i o n of business r e s u l t s no amount of c o n v e n t i o n a l and r o u t i n e c a l c u l a t i o n s i s a s u b s t i t u t e f o r t h e i r own good judgment. 8 CHAPTER I I HISTORICAL BACKGROUND The concept of the r e t u r n on investment as a measure of e n t e r p r i s e p r o f i t a b i l i t y i s not new. Accord i n g to I r i s O r i g o , Francesco,Di Marco D a t i n i , the f o u r t e e n t h century "Merchant of P r a t o " , was p o s s i b l y i n f l u e n c e d by the r a t e of r e t u r n i n s h i f t i n g ' h i s investments from one venture to another-; I t i s p o s s i b l e t h a t a r e a l i z a t i o n of the slow and s m a l l p r o f i t s of cloth-making (computed by P r o f e s s o r P. M e l l s to be 8.92%) as compared to most of h i s other e n t e r p r i s e s (average of 28% made d u r i n g seventeen years i n the v e i l t r ade) discouraged D a t i n i from t a k i n g any l a r g e r p a r t i n t h i s i n d u s t r y . His c o n t r i b u t i o n to i t , as we have seen, was some c a p i t a l and the good E n g l i s h and Spanish wool which h i s money bought. But the management of the business remained e n t i r e l y i n the hands of h i s p a r t n e r s , and a f t e r the death from the plague of both N i c o l o d i Ginuta and Francesco B e l l a n d i n i i n 1400 (the business p a s s i n g i n t o the hands of N i c o l o ' s son Angnolo), the amount of wool which D a t i n i bought f o r the company g r a d u a l l y diminished...! I n more rec e n t years management has t r i e d the r a t e of r e t u r n concept i n p r i c i n g , c a p i t a l budgeting-, e t c . I n 1920's Donaldson Brown, i n h i s c a p a c i t y of v i c e - p r e s i d e n t of the General Motors C o r p o r a t i o n , made the r a t e of r e t u r n 1 I r i s Origo. The Merchant of P r a t o , (London; : Jonathan Cape, 1957) p.76. Percentages from i n f o r m a t i o n on pp. 76 and 102. 9 on investment an i n t e g r a l p a r t of the company's p r i c i n g p o l i c y . I n h i s own words: An acceptable theory o f - p r i c i n g "must be to g a i n over a p r o t r a c t e d p e r i o d of time a margin of p r o f i t which rep r e s e n t s the h i g h e s t a t t a i n a b l e r e t u r n commensurate w i t h c a p i t a l turnover and..the enjoyment of wholesome expansion, w i t h adequate regar d to the economic consequences of f l u c t u a t i n g - volume." Thus the p r o f i t  margin t r a n s l a t e d i n t o i t s s a l i e n t c h a r a c t e r i s t i c s  r a t e of r e t u r n on c a p i t a l employed, i s the l o g i c a l  y a r d s t i c k by which to gauge the p r i c e of a commodity  w i t h r e g a r d to c o l l a t e r a l circumstances a f f e c t i n g  supply and demand.,.- ( h i s i t a l i c s j -Not u n t i l about 1948 was there much w r i t t e n on the r a t e of r e t u r n on investment. Since- then, a h i g h l e v e l of i n t e r e s t can be found i n the r a t e of r e t u r n measure i n a p p l y i n g i t to many phases of i n t e r n a l c o n t r o l . The address of T.C. Davis, the t r e a s u r e r of du Pont Company, d e l i v e r e d before A.M.A. f i n a n c e conference i n 1949, aroused a widespread i n t e r e s t i n the r a t e of r e t u r n on investment. The du Pont company has been u s i n g the r a t e of r e t u r n on investment s i n c e 1919. I n 1920's the Chart System was developed. The c h a r t s r e l a t e d " t h e r a t e of r e t u r n on investment of each d i v i s i o n and department to the o p e r a t i n g r e s u l t s of r e s p e c t i v e d i v i s i o n s and departments 1 Donaldson Brown, " P r i c i n g P o l i c y i n R e l a t i o n to F i n a n c i a l C o n t r o l s , " Management and A d m i n i s t r a t i o n , ' February, 1924, p. 197. 10 i n terms of the revenue, expense, and investment accounts. 1 Since World War Two, a number of l a r g e companies has applied, the r e t u r n on. investment as an i n t e r n a l measure of past performance.' Two s i g n i f i c a n t t r e n d s , the i n c r e a s e d d e c e n t r a l i z a t i o n and the i n c r e a s e d r a t e of investment, have c o n t r i b u t e d to the i n c r e a s e i n u s e f u l n e s s of the r a t e of r e t u r n on investment concept.. The d e c e n t r a l i z a t i o n of management and the attendant d i f f u s i o n of p r o f i t r e s p o n s i b i l i t y r e q u i r e d some check on the o v e r a l l performance of autonomous sub-units of a company. The r a t e of r e t u r n on investment measured o v e r a l l perform-ance and t h e r e f o r e answered the requirements of the d e c e n t r a l -i z e d o r g a n i z a t i o n . The business made more investment a f t e r the war than.had been made f o r many y e a r s . Gross p r i v a t e domestic investment i n the U n i t e d States averaged 8.2.per cent of the Gross N a t i o n a l Product i n t h e . p e r i o d from 1930-1939 and from 1 9 4 5 - 1 9 5 4 i t averaged 1 3 • 9 per cent, r e a c h i n g a peak of 18 per cent i n 1 9 5 0 . 2 I n Canada, business gross f i x e d c a p i t a l f o r m a t i o n was much h i g h e r ; in.the- p e r i o d from 1 9 3 0 - 1 9 3 9 i t averaged 1 0 . 4 per cent, from 1 9 4 5 - 1 9 5 4 i t averaged 16 . 7 per cent, w i t h the peak i n the l a t t e r p e r i o d — T.C. Davis, "How the du Pont O r g a n i z a t i o n Appraises I t s Performance," (New York: American Management A s s o c i a t i o n P i n a n c i a l Management S e r i e s No. 9 4 , 1 9 5 0 ) . 2 Survey of Current Business: 1957 Business S t a t i s t i c s Supplement, p . 3 « 11 of 20 per cent i n 1953> i n c r e a s i n g to 22.1 per cent i n 1956. -j With the a c c e l e r a t e d growth of investment, i t became more important to i n c l u d e the investment f a c t o r i n the measure of performance. The r a t e of r e t u r n on i n v e s t -ment measured both p r o f i t s and investment. Some managements t h i n k t h a t , i n dynamic c o n d i t i o n s , r a t e of r e t u r n on investment l o s e s s i g n i f i c a n c e . Others, l i k e I . Wayne K e l l e r , the C o n t r o l l e r of Armstrong Cork Company, are e n t h u s i a s t i c supporters of the r a t e of r e t u r n on investment. K e l l e r has t h i s to say about i t : The p r o b a b i l i t y of r e a l i z i n g optimum p r o f i t s i s s u b s t a n t i a l l y g r e a t e r i f they are planned as a per c e n t -age of r e t u r n ' o n c a p i t a l employed to produce them and the business i s managed w i t h the o b j e c t i v e of a c h i e v i n g t h i s planned r a t i o . A few American c o r p o r a t i o n s have used r e t u r n on investment on C a p i t a l employed f o r measur-i n g and c o n t r o l l i n g p r o f i t s f o r many y e a r s . As a r e s u l t they have been u s u a l l y s u c c e s s f u l . T h e i r employees at a l l l e v e l s have enjoyed r e l a t i v e l y h i g h incomes; t h e i r s t o c k h o l d e r s have r e c e i v e d h i g h dividends and have had s u b s t a n t i a l a p p r e c i a t i o n i n t h e i r e q u i t y . These compan-i e s have had out s t a n d i n g growth r e c o r d s , s u p p l y i n g more and more products at co m p e t i t i v e p r i c e s which c o n t r i b u t e d to the improvement to the economy of the n a t i o n and the ge n e r a l standard of l i v i n g . With t h i s demonstrated r e c o r d of the e f f e c t i v e n e s s of p r o f i t measurement and c o n t r o l i t i s d i f f i c u l t to understand why companies have been slow i n u s i n g I t . . I t i s on l y r e c e n t l y that i t has been r e c e i v i n g i n c r e a s e d a t t e n t i o n and has begun to be used by a growing number of companies. ^ _ N a t i o n a l Account Income and Expenditure 1926-1956, Dominion Bureau of S t a t i s t i c s , 1958, pp. 26, 27. 2 I . Wayne K e l l e r , Management Eor P r o f i t C o n t r o l (New York: McGraw-Hill, 1 9 5 7 p . 313. : 12 I t i s p o s s i b l e t h a t many managements do not f e e l t h a t the r a t e of r e t u r n on investment i s n e c e s s a r y or t h a t i t i s the key to s u c c e s s . Others may be content w i t h j u s t average p r o f i t s and may not f e e l the need o f e x e r t i n g themselves i n p u r s u i t of h i g h e r p r o f i t s . I n c r e a s e d use of r e t a i n e d e a r n i n g s f o r b u s i n e s s expansion and avoidance o f g o i n g to the market f o r the n e c e s s a r y f unds, may have been a c o n t r i b u t i n g f a c t o r to t h i s c o n s e r v a t i v e a t t i t u d e . Sometimes the r a t e of r e t u r n on investment i s an important and u s e f u l p a r t of top management c o n t r o l ; somer? times, however, i t can l e a d - a s t r a y and must t h e r e f o r e be used w i t h c a u t i o n . V ery l i t t l e r e s e a r c h has been done i n the a r e a of measurement and e v a l u a t i o n of performance; to t h i s day i t i s s t i l l a r a t h e r obscure s u b j e c t . The e x p l o r a t i o n of v a r i o u s b u s i n e s s p r o c e s s e s , t h e i r e f f e c t s and the c o r r e c t consequent a c t i o n to remedy bad o r to improve on good performance must s t i l l be undertaken. T h i s paper w i l l not t r y to s o l v e a l l these problems. Rather, a c r i t i c a l a n a l y s i s of the r a t e o f r e t u r n concept w i l l be undertaken to see how e f f e c t i v e i t i s i n e v a l u a t i n g m a n a g e r i a l performance, and to p o i n t out c e r t a i n c o n d i t i o n s under which the m a n a g e r i a l performance may be improved. 13 CHAPTER I I I BASIC THEORY OP RATE OF RETURN ON INVESTMENT I GENERAL CONSIDERATIONS B a s i c formula* The for m u l a f o r r e t u r n on investment i s the r e s u l t o f two f a c t o r s : 1. The percentage o f income on s a l e s , and 2. Turnover. ( T a b l e 1 ) . TABLE 1 Re t u r n on Investment. -r J , -p • n $10,000 1 . Income=percentage of income on s a l e s ^ onA nnn=5 per S a l e s , *200,0.00 defit 2. S a l e s ^ t u r n o v e r $200,000=2 t u r n T 5 ^ t m e n t $1UU, OUU cover Per cent Income on S a l e s x Turnover = R e t u r n on Investment 5 p er cent x 2 =10 per cent The same r e s u l t , t e n per cent on the investment o f $100,000, can be o b t a i n e d by s i m p l y r e l a t i n g ' income t o investment. I n doing so, however, the s i g n i f i c a n c e o f c o s t s i n r e l a t i o n to s a l e s and the s i g n i f i c a n c e of investment i n r e l a t i o n to s a l e s volume i s obscured. Cost p r i c e r e l a t i o n s h i p i s shown by the percentage of income on s a l e s . Investment turnover measures the i n t e n s i t y w i t h which the c a p i t a l i s employed; to the extent t h a t company can match per cent income on s a l e s of a competitor and use i t s c a p i t a l more e f f e c t i v e l y so as.to have a higher turnover, i t has a comp-e t i t i v e advantage. I f : i t can achieve both a h i g h e r income on s a l e s and a h i g h e r t u r n o v e r , i t has a d i s t i n c t advantage f o r s u r v i v a l and growth. The r e t u r n on investment can be improved i n three ways. 1 . By i n c r e a s i n g volume of s a l e s , . w h i l e m a i n t a i n -i n g the same income percentage, or by i n c r e a s -i n g net s a l e s through h i g h e r p r i c e s . 2. By r e d u c i n g c o s t s . 3. By r e d u c i n g the amount of investment through improvement i n i n v e n t o r y l e v e l s , more r a p i d c o l l e c t i o n of accounts r e c e i v a b l e , economic c o n t r o l of a d d i t i o n s to f i x e d a s s e t s , and g e n e r a l l y improved t u r n o v e r . The essence of t h i s formula and i t s a n a l y s i s l i e s i n the i n t r o d u c t i o n of a new f a c t o r , s a l e s , i n a d d i t i o n to income and investment. I t i s known as a du Pont formula and can be b r i e f l y s t a t e d as f o l l o w s : Income x Sales _ Income Sales Investment Investment 15 I t i s important t o r e a l i z e t h a t the breakdown of the r e t u r n on investment i s o n l y f o r the purposes o f a n a l y s i s . - The r a t i o o f income to s a l e s o r the r a t i o o f s a l e s to investment means l i t t l e s t a n d i n g by i t s e l f . Both must be c o n s i d e r e d t o g e t h e r . Turnover and s a l e s margin a n a l y s i s . The r e t u r n on investment f o r m u l a p r e s e n t s an e f f e c t i v e method o f a n a l y s i n g changes i n the r e t u r n on investment and i n p o i n t i n g out the areas r e q u i r i n g a t t e n t i o n . I t can be a p p l i e d to companies or d i v i s i o n s i n intra-company o r inter-company comparisons. I n Table I I , the i n t e r r e l a t i o n o f s a l e s volume, income, and investment i s a n a l y s e d i n th r e e assumed companies, TABLE I I A n a l y s i s o f r e t u r n on investment. Company A Company . B Company C S a l e s $ 5 0 0 , 0 0 0 $ 2 5 0 , 0 0 0 $ 5 , 0 0 0 , 0 0 0 Income 5 0 , 0 0 0 ; 25, ,000 2 5 , 0 0 0 Investment 2 5 0 , 0 0 0 2,9500,000 2 , 5 0 0 . 0 0 0 Income as a percentage o f s a l e s ( l i n e 2/1 ine 1.) 10 p e r cent 10 per cent 0 . 5 per cent Turnover ( l i n e 1 / l i n e 3 ) 2 .1 ,2 R e t u r n on Investment ( l i n e 4 x l i n e 5 ) 20 per cent 1; per cent 1 per cent 16 Table I I b r i n g s out a number of important f e a t u r e s of a company's p r o f i t a b i l i t y . I t p o i n t s out the way a company can improve i t s e a r n i n g s . E x c l u s i v e r e l i a n c e by Company B on the income as a percentage of s a l e s , would make i t b e l i e v e . t h a t i t was j u s t as p r o f i t a b l e as Company A; both have the s a l e s margin of ten per cent. I t would a l s o be misleading- to t h i n k t h a t Company B was more p r o f i t a b l e than Company C which earned only one-half of one per cent on i t s s a l e s as again s t Company B's t e n per cent s a l e s margin. A quick look at the r a t e s of r e t u r n on investment would d i s p e l such i l l u s i o n . Company B's p r o f i t a b i l i t y i s the same as t h a t of Company C; both have one per cent r a t e of r e t u r n on investment which i s f a r l e s s than t h a t of Company A earning as much as twenty per cent on i t s investment. I f Companies A and. B are i n the same i n d u s t r y , i n v e s t i g a t i o n of turnover by Company B.may l e a d i t to im-proved p r o f i t a b i l i t y . S i m i l a r l y , i f Company A and Company C are i n the same i n d u s t r y , Company C's i n q u i r y i n t o i t s lower income as a percentage of sales"may l e a d i t to hig h e r p r o f i t s . Assuming uniform s e l l i n g p r i c e s i n the i n d u s t r y , Company A should not be s a t i s f i e d , w i t h the income margin of twenty per cent, but i t should i n v e s t i g a t e c o s t s and f i n d ways.to reduce them and so enhance i t s p r o f i t a b i l i t y even f u r t h e r . The above r e t u r n on investment formula assumes t h a t turnover and s a l e s margin (income as a percentage of s a l e s ) are independent f a c t o r s . With s u b s t a n t i a l f i x e d expenses 17 t h i s may not he t r u e . H i g h e r t u r n o v e r w i l l tend to i n c r e a s e income as a percentage of s a l e s , p r o v i d e d the s e l l i n g p r i c e i s m a i n t a i n e d , because c o s t o f s a l e s do not, w i t h l a r g e f i x e d expenses, i n c r e a s e p r o p o r t i o n a t e l y w i t h s a l e s . While t h i s a n a l y s i s i s simple i t does, however, c o n t a i n c e r t a i n u s e f u l f e a t u r e s . , I t c o n s i d e r s the v e r y important f a c t o r o f s a l e s volume, and i t enables handling' of the r e t u r n on investment i n terms of two r a t i o s r a t h e r than i n terms of t o t a l d o l l a r f i g u r e s . R a t i o s are comparable i r r e s p e c t i v e o f the s c a l e o f b u s i n e s s ; t o t a l income and t o t a l investment are n o t . Pr o p e r a n a l y s i s o f the r a t e of r e t u r n on investment may l e a d an e n t e r p r i s e to h i g h e r p r o f i t a b i l i t y through improvements i n s a l e s , r e d u c t i o n o f c o s t s , and more e f f e c t i v e u t i l i z a t i o n o f r e s o u r c e s . The r a t e o f r e t u r n on investment concept and the r a t i o a n a l y s i s a re g a i n i n g an i n c r e a s e d acceptance i n b u s i n e s s management. Mr. W i l l i a m B. H a r r i s i n discussing"Pr>essure on P r o f i t , " has t h i s to say: T h i s downward t r e n d i n p r o f i t s developed i n the l a t t e r p a r t o f a decade t h a t , taken as a whole, shows a n e a r l y i d e a l p r o f i t r e c o r d f o r the l a r g e s t c o r p o r a t i o n s . Por the 100 l a r g e s t , f o r the f u l l decade 1 9 4 7 - 5 6 , s a l e s r o s e 1 3 6 . 9 per cent and p r o f i t s 1 3 6 . 9 per c e n t . The exact s i m i l a r i t y i s sheer c o i n c i d e n c e , o f c o u r s e , but the c l o s e s i m i l a r i t y i s n o t . The c a p i t a l used to a c h i e v e t h i s r e s u l t has r o u g h l y f o l l o w e d the h i s t o r i c p a t t e r n — 75 c e n t s i n net o p e r a t i n g investment to produce $1 i n s a l e s . Thus w h i l e the r a t i o o f p r o f i t to s a l e s r e m a i n i n g un-changed f o r the group as a. whole, p r o f i t r a t i o s on 18 c a p i t a l rose s l i g h t l y . The d e l i c a t e balance of these r a t i o s i s a key f a c t o r i n corporate performances Por a business t h a t produces higher and higher s a l e s , w h i l e m a i n t a i n i n g i t s o p e r a t i n g - p r o f i t r a t i o , and at the same time u t i l i z i n g i t s funds so w e l l t h a t i t shows c o n s i s t e n t i n c r e a s e s i n earnings on c a p i t a l , i s o p e r a t -i n g i d e a l l y , .j Por these reasons both the per cent of income on s a l e s and the investment turnover need c l o s e watching to be able to see what i s happening to•company operations and where manage-r i a l e f f o r t - needs to be concentrated. Both should be the s t r a t e g i c p o i n t s of c o n t r o l . The answer to the q u e s t i o n posed at the beginning of t h i s paper, of whether the r a t e of r e t u r n on investment r e f l e c t s the e f f e c t of f a c t o r s r e q u i r e d f o r s u c c e s s f u l oper-a t i o n , i s yes. The r a t e of r e t u r n on investment measurement does not r e f l e c t a l l the f a c t o r s i n d e t a i l , but i t does r e f l e c t the most s t r a t e g i c f a c t o r s a f f e c t i n g o p e r a t i n g performance: s a l e s , income, and investment. I t shows .management1 s .: e f f e c t i v e n e s s i n h a n d l i n g the resources e n t r u s t e d to i t . I I SIGNIFICANCE OP THE RATE OF RETURN ON INVESTMENT MEASURE The performance of most businesses i s evaluated by s t o c k h o l d e r s , c r e d i t o r s , and other i n v e s t o r s by the 1 • W i l l i a m B. H a r r i s , "Pressure on P r o f i t s , " Fortune, November, 1957, p. 121. 19 percentage r e t u r n the company makes on the c a p i t a l i n v e s t e d . A l l e n t e r p r i s e s must compete f o r c a p i t a l w i t h o t h e r e n t e r -p r i s e s and the r e t u r n on c a p i t a l remains the u l t i m a t e c r i t e r -i o n f o r c o n t i n u a t i o n o f . t h e b u s i n e s s . S i n c e top management,is'being e v a l u a t e d i n terms of the company's r a t e of r e t u r n , the l o g i c a l t h i n g to do i s to use the same y a r d s t i c k , as a. guide i n i t s a c t i o n s and d e c i s i o n s . P r o f i t a b i l i t y , however, i s not the o n l y c r i t e r i o n on which any p a r t i c u l a r d e c i s i o n may be based. -.Non-financial c o n s i d -e r a t i o n s may be j u s t as important as. p r o f i t a b i l i t y . I t i s assumed, however, t h a t the r a t e of r e t u r n on.investment i s an important guide to top management a c t i o n s . The e v a l u a t i o n by management of i t s d e c i s i o n s and any proposed a c t i o n are l i k e l y to be c o n s i d e r e d i n the l i g h t of t h e i r e f f e c t on the company's r a t e of r e t u r n on: i n v e s t m e n t . How s t o c k h o l d e r s e v a l u a t e a company's performance i s w e l l expressed i n W a l t e r Pepke's a r t i c l e ' i n F o r b e s : The o n l y t h i n g t h a t r e a l l y counts i n b u s i n e s s i s how w e l l management i n v e s t s i t s d o l l a r s . I n s h o r t , what k i n d o f a r e t u r n i t earns on i t s c a p i t a l . A company can e a s i l y go broke j u s t p i l i n g up s a l e s and a s s e t s . A l l a s t o c k h o l d e r r e a l l y wants to know i s t h i s : How much are the e a r n i n g s and how much of them can I get ?^ As s t a t e d b e f o r e , companies which do not r e l y on market f o r the s u p p l y of funds may t e m p o r a r i l y d i s r e g a r d the e v a l u a t i o n o f t h e i r r e s u l t s i n terms o f the r a t e of r e t u r n . 1 W a l t e r Pepke, " P r o f i t Package," For b e s , October 1, 1958, p. 11. . However, p r o f i t i s the l i f e h l o o d of b u s i n e s s ; d i m i n i s h i n g p r o f i t w i l l compel such e n t e r p r i s e s to. concern themselves, sooner or l a t e r , w i t h the rate>of r e t u r n i f they want to s t a y i n b u s i n e s s . 21 CHAPTER IV OBJECTIVES AND CONDITIONS POR EFFECTIVE ' PERFORMANCE MEASUREMENT AND EVALUATION I OBJECTIVES- OP PERFORMANCE MEASUREMENT " Statement of o b j e c t i v e s . J o e l Dean f e e l s t h a t t h e r e are two o b j e c t i v e s o f i n t e r n a l performance measurement: These arei,: f i r s t , the guidance o f the d i v i s i o n o r o t h e r i n t e r n a l management — whose r e s u l t s are b e i n g measured and, second, the a s s i s t a n c e of top management and i t s s t a f f i n t h e i r t a s k s o f a p p r a i s i n g and g u i d i n g d i v i s i o n a l performance.^ He emphasizes these two o b j e c t i v e s by adding l a t e r , "and, a s i d e from such u s u a l l y d e s i r a b l e c h a r a c t e r i s t i c s as s i m p l i c i t y , these are the o n l y ( h i s i t a l i c s ) o b j e c t i v e s o f a measurement system." J o e l Dean's o b j e c t i v e s o f i n t e r n a l p r o f i t measure-ment can be digramed as f o l l o w s : F i r s t O b j e c t i v e — Por D i v i s i o n a l Management A. To f u r n i s h a guide f o r d i v i s i o n management. 1 J o e l Dean, "An Approach To I n t e r n a l P r o f i t M e a s u r e m e n t N . A . A . B u l l e t i n , March, 1958, p.5. 22 B. To f u r n i s h a method by which d i v i s i o n a l management can e v a l u a t e i t s own performance. Second O b j e c t i v e — f o r Top Management A. To a s s i s t top management i n the e v a l u a t i o n of d i v i s i o n a l performance. B. To guide d i v i s i o n a l performance by p o i n t i n g out areas r e g u i r i n g a t t e n t i o n . The purposes of i n t e r n a l measurement are s t a t e d i n terms o f people and s i n c e t h i s paper concerns i t s e l f . l a r g e l y w i t h m a n a g e r i a l performance i t w i l l be a c o n v e n i e n t p o i n t to base f u r t h e r d i s c u s s i o n . Both' o b j e c t i v e s w i l l be i n v o l v e d i n a p p r a i s a l of m a n a g e r i a l performance; both are e q u a l l y import-a n t . A c c o r d i n g to Dean: Many view the second of these o b j e c t i v e s , namely, measuring d i v i s i o n a l performance as i f i t were the o n l y one or at l e a s t the more important o f the two. Our f i r m e x p e r i e n c e i n c l i n e s me t o b e l i e v e t h a t most companies': p r o f i t s are a f f e c t e d a t l e a s t as much by the i n f l u e n c e of a measurement system on the day-to-day b e h a v i o u r of d i v i s i o n management as by t h e a s s i s t a n c e these measure-ments g i v e to top measurement l a t e r on.^ D i v i s i o n managers w i l l use t h a t y a r d s t i c k which they t h i n k i s used t o e v a l u a t e t h e i r performance, i t may be s a l e s c l e a n desk, or p r o f i t . I t i s , t h e r e f o r e , important t h a t _ I b i d . , p. 5. 2 3 performance measuring standard or standards are w e l l known to those concerned, otherwise d i v i s i o n managers are apt to maximize whatever they t h i n k i s used, hy top.management i n performance a p p r a i s a l ; d i v i s i o n managers 1 conception of what c o n s t i t u t e s a good performance may not c o i n c i d e w i t h the top management's i n t e n t and r e s u l t i n a c t i o n s not i n accord w i t h company o b j e c t i v e s . I . Wayne K e l l e r does not d i s t i n g u i s h between the two o b j e c t i v e s : The purpose of the r e t u r n on c a p i t a l r a t i o i s f o r i n t e r n a l p r o f i t measurement and a p p r a i s a l . Trends are more s i g n i f i c a n t than percentage r a t i o s . Consistency i s of prime importance and the a s s e t s i n c l u d e d and the method of t h e i r e v a l u a t i o n w i l l not destroy the e f f e c t i v e use of the r a t i o s so l o n g as they are determined on the same b a s i s year a f t e r year and f o r a l l measurement purposes.^ Many would not agree w i t h t h i s statement and would i n s i s t on a c e r t a i n v a l u a t i o n of a s s e t s . But f o r a g e n e r a l inter-company comparison t h i s statement may be t r u e . F a c t o r s o u t s i d e managerial c o n t r o l . Any e v a l u a t i o n of managerial performance must discount "factors o u t s i d e managerial c o n t r o l . The o p e r a t i n g r e s u l t s of a company or a d i v i s i o n w i l l be caused by a combination of c o n t r o l l a b l e and u n c o n t r o l l a b l e f a c t o r s and any system of measurement w i l l r e f l e c t both. I n order to evaluate performance of manage-ment, assumptions must be made about the extent to which I . Wayne K e l l e r , "The Return on C a p i t a l Concept," N.A.A. B u l l e t i n , March, 1958, p. 17. 24 u n c o n t r o l l a b l e f a c t o r s have a f f e c t e d the o p e r a t i n g r e s u l t s . Among u n c o n t r o l l a b l e f a c t o r s t h a t may be mentioned, g e n e r a l business c o n d i t i o n s are the most important. I n d i v i s i o n a l performance the u n c o n t r o l l a b l e f a c t o r s may o r i g i n a t e i n top management p o l i c i e s or a c t i o n s i n other d i v i s i o n s . The crux of the problem i s how to separate the i n f l u e n c e of f a c t o r s which are beyond the c o n t r o l of any r e s p o n s i b l e i n d i v i d u a l . Although t h i s s e p a r a t i o n i s sometimes d i f f i c u l t , an e f f o r t must be made to separate d e l i b e r a t e l y or otherwise the u n c o n t r o l l a b l e and c o n t r o l l a b l e aspects of performance i f any v a l i d e v a l u a t i o n i s to be made of the persons involved.. C o n f l i c t of o b j e c t i v e s . I n some cases l o n g and s h o r t - r u n o b j e c t i v e s "may be i n c o n f l i c t . The maximization of s h o r t - r u n p r o f i t s may be at odds w i t h the long-run o b j e c t -i v e s of s u r v i v a l and growth. C o n f l i c t can a l s o a r i s e between a c t i o n s taken to improve c u r r e n t performance of. a d i v i s i o n or a company and a c t i o n s which are aimed at improving l o n g -r u n p r o f i t a b i l i t y . Research or maintenance are good examples. Postponment of e i t h e r may r e s u l t i n the improvement i n c u r r e n t performance but, as a r u l e , at the expense of the l ong-run operations and a b i l i t y to compete. I I CONDITIONS POR EFFECTIVE PERFORMANCE 'MEASUREMENT AND'EVALUATION IN TERMS OF RATE OF RETURN~ON'INVESTMENT. I t i s extremely d i f f i c u l t to devise c o n d i t i o n s under which the r a t e of r e t u r n on investment w i l l i d e a l l y measure 25 managerial,performance. What i s r e q u i r e d i s the measure of achievement of company's g o a l s . This i s made ver y complex by the f a c t t h a t businesses u s u a l l y have s e v e r a l o b j e c t i v e s which o v e r l a p and to some degree c o n f l i c t : p r o f i t s , s o c i a l , acceptance, employee s a t i s f a c t i o n , development Of new order-,., growth, market share, and e t e r n a l l i f e . Because of our f r e e e n t e r p r i s e system and o b l i g a t -ions to i n v e s t o r s , p r o f i t s are u s u a l l y the dominant g o a l of business a c t i v i t y . They can u s u a l l y be measured w i t h reason-able accuracy; o t h e r ' o b j e c t i v e s cannot be so r e a d i l y p r e s e n t -ed i n q u a l i t a t i v e form. The other o b j e c t i v e s c o n t r i b u t e i n d i f f u s e ways to long-run p r o f i t s and thus eannot.be igno r e d i n measuring and e v a l u a t i n g managerial performance. The main performance of e x e c u t i v e s , however, remains r e f l e c t e d i n i t s c o n t r i b u t i o n to company p a s t , p r e s e n t , and f u t u r e p r o f i t s . The attempt was made to present c e r t a i n c o n d i t i o n s where the r a t e of r e t u r n on investment can r e f l e c t o p e r a t i n g performance of management most e f f e c t i v e l y . These c o n s i d -e r a t i o n s may be u s e f u l to d e c e n t r a l i z e d companies d e s i r i n g to use the r e t u r n on investment as a method of measuring and e v a l u a t i n g e x e c u t i v e performance. Company l e v e l . Every economic f a c i l i t y employed by the e n t e r p r i s e should be c a r e f u l l y administered by the top management w i t h a view to income; the r e t u r n , on i n v e s t -ment shows the e f f e c t i v e n e s s w i t h which the management handled the a v a i l a b l e resources e n t r u s t e d to i t s c a r e . 26 Income,however, may he due t o a c o n t r i b u t i o n of c o n t r o l l a b l e and u n c o n t r o l l a b l e f a c t o r s . . The e f f e c t i v e n e s s of the r a t e of r e t u r n on investment i n e v a l u a t i n g perform-ance w i l l t h e r e f o r e be g r e a t e r i f : 1. C o n t r o l l a b l e and u n c o n t r o l l a b l e f a c t o r s are separated. 2. Performance i s measured ag a i n s t a r e a l i s t i c s tandard. U n c o n t r o l l a b l e f a c t o r s cannot be f u l l y i d e n t i f i e d and e l i m i n a t e d . Judgment must be employed. Standards must-be determined i n l i n e w i t h other business o b j e c t i v e s and c o m p e t i t i o n . This means t h a t they are not absolute but r a t h e r depending on the best p o s s i b l e achievement under the e x i s t i n g circumstances. D i v i s i o n l e v e l . On the d i v i s i o n a l , l e v e l , the r e t u r n on investment w i l l e f f e c t i v e l y measure executive performance i f the company i s d i v i d e d i n t o independent oper a t i n g u n i t s which a c t l i k e economic e n t i t i e s f r e e to trade i n s i d e and.outside the company. P r o p e l l e d by a p p r o p r i a t e i n c e n t i v e s , each d i v i s i o n w i l l t r y to maximize i t s own c o n t r i b u t i o n to g e n e r a l overhead and p r o f i t s which w i l l a l s o maximize the p r o f i t s of the e n t i r e company. C e r t a i n c o n f l i c t s may a r i s e from the d i v i s i o n ' s attempt .to maximize i t s own p r o f i t s . This problem w i l l be developed i n f u r t h e r d i s c u s s i o n . D i v i s i o n a l manager can be made r e s p o n s i b l e f o r the performance of h i s d i v i s i o n and h i s o p e r a t i n g performance 27 can "be evaluated i n terras of the r a t e of r e t u r n on investment i f the f o l l o w i n g c o n d i t i o n s are f u l f i l l e d : 1. The d i v i s i o n a l boundaries are marked o f f so as to preserve o p e r a t i o n a l autonomy pf the d i v i s i o n manager, w i t h c o s t , revenue, and investment s e p a r a t e l y recorded f o r h i s d i v i -s i o n and a minimum of a l l o c a t i o n used. 2. Intra-company p r i c e s are n e g o t i a t e d i n arm's l e n g t h b a r g a i n i n g by d i v i s i o n managers w i t h access to data on a l t e r n a t i v e sources and markets and freedom to d e a l w i t h o u t s i d e r s . 3. D i v i s i o n a l c o n t r i b u t i o n p r o f i t s are measured c o r r e c t l y , i . e . , p r o f i t s over which the d i v i s -i o n a l manager has c o n t r o l . 4. R e a l i s t i c standards of c o n t r i b u t i o n p r o f i t performance are determined by review of past r e c o r d and c o n s i d e r a t i o n o f . c u r r e n t economic c l i m a t e and c o m p e t i t i v e c o n d i t i o n s i n the i n d u s t r y . 5. Proper i n c e n t i v e s are e s t a b l i s h e d and r e l a t e d to the c o n t r i b u t i o n p r o f i t s of the d i v i s i o n . 6. Investments are s u b j e c t to n e g o t i a t i o n w i t h top management. 28 7. The d i v i s i o n manager i s not r e s p o n s i b l e f o r d e c i s i o n s made before he took over, unless he i s p ermitted to r e v i s e the previous d e c i s i o n . R e f e r r i n g to e v a l u a t i o n of d i v i s i o n a l performance, Dean has t h i s to say: C o n t r i b u t i o n p r o f i t s as a r e t u r n on investment provides the most important guide to top management i n e v a l u a t i n g of p r o f i t center performance.^ Dean's comment i s t r u e , but o n l y i f most of the above c o n d i t i o n s "are f u l f i l l e d . Not a l l companies are w i l l i n g ' or able to go the l e n g t h suggested here. The p r i c e asked f o r o b j e c t i v i t y may be too h i g h . 1 J o e l Dean, " P r o f i t Measurement of D i v i s i o n Managers," The C o n t r o l l e r , September, 1957, p. 426. 29 CHAPTER V PROBLEMS OP INCOME DEFINITION, There i s not j u s t one best way to c a l c u l a t e the r a t e of r e t u r n f o r a d i v i s i o n or a eompany. Both the investment and the income f i g u r e s can he computed i n many d i f f e r e n t ways r e s u l t i n g i n s i g n i f i c a n t r a t i o v a r i a t i o n s . The d e f i n -i t i o n of income i s c l o s e l y r e l a t e d to the problem of v a l u a t i o n of the investment base and the d e f i n i t i o n of one must be c o n s i s t e n t w i t h the d e f i n i t i o n of the o t h e r . Most of the d i s c u s s i o n i n the l i t e r a t u r e on the a l t e r n a t i v e methods has been concerned w i t h f i n d i n g an accurate r a t e of r e t u r n — or perhaps even some k i n d of " t r u e " r a t e of r e t u r n . L i t t l e has been s a i d about the use of r a t e of r e t u r n on investment i n g u i d i n g and e v a l u a t i n g d i v i s i o n a l and top management performance. General background. The management i s not bound to use an accounting concept of income i n g u i d i n g and e v a l u a t i n g d i v i s i o n a l management and i n making' d e c i s i o n s . Up to the present time, however, no b e t t e r p r a c t i c a l ways of computing income have been advanced than those developed by the accounting p r o f e s s i o n . I t i s suggested then t h a t the best accounting concept of income, w i t h proper m o d i f i c -a t i o n s , be used In the r a t e of r e t u r n a n a l y s i s . Before a c c e p t i n g the accountant's concept of income i n performance a p p r a i s a l , i t i s important to r e a l i z e c e r t a i n l i m i t a t i o n s i n h e r e n t i n the income concept and beware of a 3 0 b l i n d r e l i a n c e i n i t s p r o p r i e t y and o b j e c t i v i t y . I n g e n e r a l , the accounting concept of business income i s an excess of revenues over cos t s i n c u r r e d i n producing- the revenues. Paton and L i t t l e t o n say t h a t , "Cost i s the amount of ba r g a i n e d - p r i c e of goods or s e r v i c e s r e c e i v e d or of s e c u r i t i e s i s s u e d i n t r a n s a c t i o n s between independent p a r t i e s . " ^ "Ba r g a i n e d - p r i c e " i s simply a u n i t p r i c e times q u a n t i t y . "Revenue," accord i n g to Paton and L i t t l e t o n , " i s the product of the e n t e r p r i s e , measured by the amount of new assets r e c e i v e d from customers; income emerges when the assets which express revenue exceed the t o t a l of a s s i g n a b l e c o s t s . " 2 I t i s i m p l i c i t i n the concept of business e n t i t y , a company or a d i v i s i o n , t h a t p r o p e r t y dedicated to bus-iness purposes belongs to the e n t e r p r i s e r a t h e r than the i n v e s t o r s . Therefore, i t should be accounted f o r s e p a r a t e l y from the p r o p e r t y of the i n v e s t o r s who are, however, e n t i t l e d to share i n the income produced by the e n t e r p r i s e a s s e t s . Management i s e n t r u s t e d w i t h the a d m i n i s t r a t i o n of a l l the e n t e r p r i s e a s s e t s ; i t s e f f e c t i v e n e s s i n ha n d l i n g the a v a i l -able resources i s , t h e r e f o r e , r e f l e c t e d i n an emerging- income, which i s the primary g o a l of a l l business a c t i v i t y . I n d i s c u s s i n g the purpose of accounting-, Paton and L i t t l e t o n s t r e s s t h i s p o i n t by s a y i n g t h a t : -W.A. Paton and A.C. L i t t l e o n , An I n t r o d u c t i o n to  Corporate Accounting Standards (American Accounting A s s o c i a t i o n Monograph No. 3 , 1 9 5 7 ) , p. 24. 2 I b i d . , p. 46. 31 A c c o u n t i n g e x i s t s p r i m a r i l y as a means of comput-i n g a r e s i d i u m , a b a l a n c e , the d i f f e r e n c e between c o s t s (as e f f o r t s ) , and revenues (as accomplishments) f o r i n d i v i d u a l e n t e r p r i s e s . The d i f f e r e n c e r e f l e c t s manag-e r i a l e f f e c t i v e n e s s and i s of p a r t i c u l a r s i g n i f i c a n c e to those who f u r n i s h the c a p i t a l and take the u l t i m a t e r e s p o n s i b i l i t y . ^ I n e v a l u a t i n g m a n a g e r i a l performance, the income f i g u r e i s v e r y im p r o t a n t . But the d e t e r m i n a t i o n o f b u s i n e s s income i s a complex problem i n a c c o u n t i n g . D i f f e r i n g s i t u a -t i o n s may r e q u i r e a departure from the a c c e p t e d standards and c o n v e n t i o n s . The " t r u e " income f i g u r e can o n l y be a r r i v e d a t on the d i s s o l u t i o n o f a b u s i n e s s o r c o m p l e t i o n o f a v e n t u r e . Computation of income f i g u r e i n case o f a m e d i e v a l merchant a d v e n t u r e r was c o m p a r a t i v e l y s i m p l e . H i s b u s i n e s s c o n s i s t e d of a s e r i e s o f i s o l a t e d v e n t u r e s , and the income on each was s i m p l y the d i f f e r e n c e between the c a p i t a l sunk i n each v e n t u r e and the sum r e a l i z e d on i t s c o m p l e t i o n . B e f o r e the b e g i n n i n g and a f t e r the end o f each v e n t u r e , the merchant was c o m p l e t e l y " l i q u i d " and so the growth i n h i s c a p i t a l was e a s i l y measured. I t i s when b u s i n e s s e n t e r p r i s e s become continuous e n t i t i e s t h a t i t becomes d i f f i c u l t to a t t r i b u t e the income of such an e n t e r p r i s e to p a r t i c u l a r s h o r t p e r i o d s o f time, 1 I b i d . , p. 16. 32 such as a year. Por i f income of the e n t e r p r i s e f o r a p a r t i c u l a r p e r i o d i s regarded as being the growth i n i t s c a p i t a l d u r i n g the p e r i o d ( a f t e r a d j u s t i n g f o r new c a p i t a l i n t r o d u c e d or amounts withdrawn), a value should be p l a c e d on the e n t e r p r i s e at the b e g i n i i i n g and end of the p e r i o d , i n order to'measure t h i s growth. And s i n c e a c o n t i n u i n g e n t e r - , p r i s e w i l l be c a r r y i n g s t o c k s of goods, investments, equipment, l a n d and b u i l d i n g s , and such i n t a n g i b l e " r i g h t s " as patents and c o p y r i g h t s or at l e a s t some of these a s s e t s j as w e l l as ass e t s l i k e cash and book debts w i t h a known face v a l u e , the problem of v a l u a t i o n becomes very d i f f i c u l t . The problem i s to some extent s o l v e d by the i n t r o -d u c t i o n of the concept of matching revenues and c o s t s . The fundamental problem, on t h i s view, i s to d i s t i n q u i s h between (a) those expenditures which should be charged a g a i n s t c u r r e n t revenue and (b) those expenditures which should be c a r r i e d forward to be charged a g a i n s t the revenue of f u t u r e p e r i o d s . These l a t t e r expenditures w i l l , u n t i l they are charged to revenue, be c a r r i e d i n the balance sheet, but whether they appear there d e s c r i b e d as " p l a n t " or " s t o c k " or " p r e l i m i n a r y expenses" or otherwise they are always viewed as past expenditures h e l d i n suspense. I t i s u s u a l l y claimed f o r the "matching c o s t s and revenue" approach to income measurement t h a t i t i s o b j e c t i v e i n t h a t ' i t avoids v a l u a t i o n s as f a r as p o s s i b l e , and s u b s t i t u t e s c o s t a l l o c a t i o n s . I t i s the best method of 33 income d e t e r m i n a t i o n d e v i s e d thus f a r ; c l o s e r examination, however, r e v e a l s c e r t a i n f l a w s . C o n s i d e r , f o r example, t y p i c a l e x p e n d i t u r e s which need to he a l l o c a t e d between two o r more t r a d i n g p e r i o d s — say the c o s t o f c e r t a i n items of p l a n t which w i l l l a s t f o r s e v e r a l y e a r s , or the c o s t of goods bought i n a number of l o t s at d i f f e r e n t p r i c e s , and s o l d over a p e r i o d of two or t h r e e y e a r s . Is t h e r e r e a l l y , i n the f i r s t case, any one o b j e c t i v e method of a l l o c a t i n g the c o s t s of the p l a n t to each of the years which enjoy i t s s e r v i c e s ? Or of s a y i n g , i n the second case, what i s the c o s t of goods s o l d i n any one p e r i o d i f s a l e l o t s cannot a c t u a l l y be i d e n t i f i e d as h a v i n g been purchased at a p a r t i c u l a r p r i c e , because i d e n t i c a l goods are f l o w i n g i n and out of the b u s i n e s s c o n t i n u a l l y w h i l e p r i c e s are changing a l l the time. The f i r s t o f these problems i s perhaps more f a m i l i a r as a problem.of c a l c u l a t i n g the d e p r e c i a t i o n o f f i x e d a s s e t s . The second, t h a t o f computing the c o s t of goods s o l d d u r i n g the y e a r i s s i m p l y another aspect o f the problem of s t o c k v a l u a t i o n because whatever o u t l a y s are not c a r r i e d f o r w a r d as s t o c k s must be charged i n the y e a r ' s a c c o u n t s . I n c a l c u l a t i n g d e p r e c i a t i o n charge, s t r a i g h t - l i n e , r e d u c i n g b a l a n c e , and o t h e r methods are used. The income f i g u r e w i l l be d i f f e r e n t i n a l l cases and the charge w i l l o n l y i n c i d e n t a l l y c o i n c i d e w i t h the e f f o r t ex-pended to e a r n p e r i o d i c income.. I n i n v e n t o r y v a l u a t i o n , " l a s t - i n , f i r s t - o u t , " " f i r s t - i n , f i r s t - o u t , " and average methods are commonly"used, each p r o d u c i n g a " d i f f e r e n t income f i g u r e . 34 The d e t e r m i n a t i o n of "business income i s to a great extent s u b j e c t i v e . The accounting p r o f e s s i o n has f o r a h a l f a century been attempting i n t e r m i t t e n t l y and w i t h inadequate power to improve on t h i s s u b j e c t i v e concept and a r r i v e at o b j e c t i v e and reasonably narrow range of meanings. The E n g l i s h c o u r t s , which have w r e s t l e d w i t h the problem of measuring business income over a l o n g p e r i o d of time, have i n the language of the House of l o r d s i n Davey v.: Cory: ... d e c l i n e d to attempt to t r e a t these questions i n the a b s t r a c t or to do t h a t which Parliament has r e -f r a i n e d from doing, namely to formulate p r e c i s e r u l e s f o r the guidance or embarrassment of business men i n the conduct of business a f f a i r s . ^ There i s another problem of the f a l l a c y of account-i n g assumption of money being a.constant measuring r o d and the consequences t h e r e o f . I t w i l l be t r e a t e d i n subsequent chapter d e a l i n g w i t h the problem of v a l u a t i o n of a s s e t s . In p r a c t i c e , d i f f e r e n t methods of computing income are used by d i f f e r e n t companies. This together w i t h an i m p o s s i b i l i t y of determining the " t r u e " income l i m i t the c o m p a r a b i l i t y of income f i g u r e s between companies and d i v i s i o n s . The l i m i t i n g f a c t o r s should always be born i n mind when e v a l u a t i n g performance i n terms of the r a t e of r e t u r n on investment. Henry B. Buckley (Lord Wrenbury), The Law and  P r a c t i c e Under,the Companies Act (Eleventh e d i t i o n ; London: Stevens, 1930), p. 756. 35 I INCOME DEFINITIONS FOR INTER-COMPANY ' COMPARISONS • Any d e f i n i t i o n of income should he c o n s i s t e n t w i t h the d e f i n i t i o n of investment when the two are r e l a t e d i n the r a t e of r e t u r n on investment. G e n e r a l l y , income should he d e f i n e d as a l l income a r i s i n g out of the use of the a s s e t s f o r which the manage-ment . i s h e l d r e s p o n s i b l e and over which the management, has c o n t r o l . To d e f i n e income i n any other way i s to l i m i t i t s u s e f u l n e s s i n a p p r a i s i n g managerial performance. This means t h a t income, f o r the purposes of r e t u r n of investment measurement i n appraising- performance, i s the net income.figure a f t e r a l l c o s t s and expenses r e q u i r e d to produce i t . The net income f i g u r e , should i n c l u d e operating-income and n o n - r e c u r r i n g items over which management has c o n t r o l . I n practice., t h i s a l l - i n c l u s i v e concept of income i s - t h e b e s t , because experience shows th a t most of non-r e c u r r i n g items of income or o r d i n a r y . l o s s e s are under managerial c o n t r o l and a c t u a l l y do r e c u r , and because the l i n e of demarcation between o p e r a t i n g items and non-o p e r a t i n g items i s not c l e a r - c u t and i s o f t e n a matter of o p i n i o n . E x t r a o r d i n a r y l o s s e s or gains f o r which the management cannot be h e l d r e s p o n s i b l e should be excluded. ...In..the p u b l i s h e d l i t e r a t u r e , the p r i n c i p a l questions which a r i s e i n d e f i n i n g income center around the f o l l o w i n g three c a t e g o r i e s of items: 36 1 . Dividend income, i n t e r e s t income, and "other income." 2. I n t e r e s t expense, income t a x e s , and "other expense." 3. D e p r e c i a t i o n expense. These items are examined i n the f o l l o w i n g p a r a -graphs i n terms of the c r i t e r i a e s t a b l i s h e d above: r e s p -o n s i b i l i t y , c o n t r o l , and c o n s i s t e n c y . D i v i d e n d income, i n t e r e s t income,and - other income. Where dividends and i n t e r e s t are items of income, most companies i n c l u d e these items i n earnings f o r the.purpose of measuring r e t u r n on investment. "Other income," f o r example gains on s a l e of a s s e t s , i s g e n e r a l l y , i n c l u d e d . Some companies, however, exclude Mother income" on the grounds t h a t items f a l l i n g i n t o t h i s category a r e . o f t e n n o n - r e c u r r i n g , such as s a l e s of major a s s e t s , and, conse-qu e n t l y , have noth i n g to do w i t h e a r n i n g power. Since management i s r e s p o n s i b l e f o r e f f e c t i v e u t i l i z a t i o n of a l l company a s s e t s , the t h r e e " c a t e g o r i e s of income should be i n c l u d e d i n net income i n computing the ra t e , of r e t u r n . o n investment, p r o v i d e d the management has the r e q u i s i t e c o n t r o l to cause the income to emerge. I n e v a l u a t i n g managerial performance a l l income, o p e r a t i n g and non-operating, should be merged i n t o one t o t a l f i g u r e . I n the f i n a l a n a l y s i s , there i s no d i f f e r e n c e between income, 37 as expressed i n money terms, which a r i s e s from o r d i n a r y oper-a t i o n s and d i v i d e n d or other income; a l l represent good money.! This i s not to say t h a t s e p a r a t i o n , i n t o income c a t -e g o r i e s i s not d e s i r a b l e ; on the contrary,- i n a n a l y s i n g the rate, of r e t u r n on investment i t i s imperative t h a t v a r -ious k i n d s of income he d e f i n i t e l y i d e n t i f i e d w i t h the under-l y i n g investment to see how the t o t a l r e s u l t i s made up and to make the necessary improvements. The management i s e n t r u s t e d w i t h c e r t a i n resources and i t i s up to i t s i n g e n u i t y and f o r e s i g h t to i n v e s t them i n those a c t i v i t i e s which r e s u l t i n the best p o s s i b l e r e t u r n . I n t e r e s t expense, income ta x e s , and other expense. Since t h e . r a t e of r e t u r n on investment i s used to measure performance of management, i . e . , e f f e c t i v e n e s s of u t i l i z a t -i o n of r e s o u r c e s , i n t e r e s t on debt should be excluded from expenses. Some concerns w i l l borrow a l a r g e r p o r t i o n of t h e i r c a p i t a l requirments than others in., s i m i l a r l i n e s ; some may leave a l a r g e r p o r t i o n of t h e i r earnings i n the business from time to time and others a v o i d the n e c e s s i t y of heavy borrowings. The management i s r e s p o n s i b l e f o r e f f e c t i v e u t i l i z a t i o n of a l l resources i r r e s p e c t i v e of where they come from. I n the words of Paton and L i t t l e t o n : Prom"the p o i n t of view of the e n t e r p r i s e as an economic e n t i t y and a center of managerial a c t i v i t y , 38 on the other hand, treatment of i n t e r e s t as a charge analogous to o p e r a t i n g c o s t s such as l a b o r and mater-i a l s i s o b j e c t i o n a b l e . To management"the cost of o p e r a t i n g the undertaking i s not a f f e c t e d by the form of c a p i t a l s t r u c t u r e employed, nor by the p a r t i c u l a r k i n d s of instruments used i n r a i s i n g the necessary funds. To management the bondholders 1 d o l l a r s and the money f u r n i s h e d by the s t o c k h o l d e r s become amalgamated i n the body of resources s u b j e c t to' a d m i n i s t r a t i o n , and the net income of the e n t e r p r i s e c o n s i s t s of the e n t i r e amount a v a i l a b l e f o r apportionment among a l l c l a s s e s of i n v e s t o r s . I n t e r e s t charges, from t h i s s t a n d -p o i n t , are not o p e r a t i n g c o s t s but represent a d i s t r i b -u t i o n of income, somewhat a k i n to dividends... The p o i n t to be noted i s t h a t s u r p l u s net income i s s u b s t a n t i a l l y a f f e c t e d by the manner i n which a company i s f i n a n c e d , w h i l e the income from o p e r a t i o n s i s q u i t e u n a f f e c t e d thereby. C a p i t a l s t r u c t u r e of a company w i l l , a f f e c t the r e t u r n on s t o c k h o l d e r s * investment. I t i s f o r f i n a n c i a l management to determine t h a t s a t i s f a c t o r y income.earned i n the conduct of a business i s r e a l i z e d by the s t o c k h o l d e r s to the f u l l e s t extent i n the form of s u r p l u s net income. The net income f i g u r e used f o r inter-company comparisons i s u s u a l l y income a f t e r t a x e s ; taxes are c o n s i d -ered to be a c o s t which must be covered before there can be a r e t u r n on investment. What i s wanted, however, i s the r e t u r n on investment over which management has c o n t r o l and no management has any c o n t r o l over t a x r a t e s . On t h i s view, i t seems l o g i c a l to use net income before t a x e s . I n a d d i t i o n , c o m p a r a b i l i t y of income f i g u r e s over time i s not a f f e c t e d by 1 W.A. Paton and A.C. L i t t l e t o n , An I n t r o d u c t i o n to  Corporate Accounting .Standards (American Accounting A s s o c i a t i o n Monograph Wo. 3, 1957), pp. 43-44. 39 changing t a x r a t e s . I f d e s i r e d , c a l c u l a t i o n of the net income f i g u r e a f t e r taxes can he made. The Monsanto Company computes the net income f i g u r e both before and a f t e r t a x e s : •Net income, 1 as used i n the c a l c u l a t i o n , i s the net-income a f t e r a l l c o s t s and expenses. The p e r c e n t -age of r e t u r n on investment based on net income a f t e r taxes i s the p r i n c i p a l y a r d s t i c k . However, we a l s o determine the r e t u r n of net income before taxes i n order to make comparisons which e l i m i n a t e the e f f e c t of changes i n tax r a t e s . companies take i n t o account "other expense" i n c a l c u l a t i n g t h e i r r e t u r n on investment. Using the c r i t e r i a . o f respons-i b i l i t y and c o n t r o l , ' " o t h e r expense" and l o s s e s , i f c o n t r o l -l a b l e , should.be i n c l u d e d i n the computation of the net income f i g u r e . be i n c l u d e d i n o p e r a t i n g expenses. D e p r e c i a t i o n i s not an o p t i o n a l charge to be r e c o g n i z e d or not as management p l e a s e s . Obsolescence i s an important f a c t o r i n d e p r e c i a t i o n of a s s e t s . Absence of... a c t i v i t y does not a r r e s t d e p r e c i a t i o n ; i t should be a charge to income i r r e s p e c t i v e of whether income has been earned or not, whether income can or cannot "stand the charge." The r e a l amount of income i s determined by oper-a t i n g a c t i v i t i e s and economic c o n d i t i o n s ; i t i s not a f f e c t e d by the management's p o l i c y w i t h r e s p e c t to d e p r e c i a t i o n . As w i t h "other income" di s c u s s e d above, most D e p r e c i a t i o n expense. D e p r e c i a t i o n should always 40 C o n c l u s i o n . The e f f e c t i v e n e s s w i t h which a l l the e n t e r p r i s e r e s o u r c e s are u t i l i z e d hy management s h o u l d he r e f l e c t e d i n the income f i g u r e emerging from the use o f those r e s o u r c e s . T h e r e f o r e , i n a d d i t i o n to.income from o p e r a t i o n s , the net income f i g u r e s h o u l d i n c l u d e d i v i d e n d income, i n t e r e s t income, and o t h e r income. Por inter-company comparisons, the net income f i g u r e s h o u l d he c a l c u l a t e d a f t e r a l l c o s t s and expenses i n c l u d i n g d e p r e c i a t i o n , .whieh are i n c u r r e d i n i t s p r o d u c t i o n , hut b e f o r e charges f o r i n t e r e s t and income t a x e s . A charge f o r d e p r e c i a t i o n i s an element o f c o s t s j u s t as any o t h e r o p e r a t i n g expense; i t s r e a l amount depends on the o p e r a t i n g a c t i v i t y o f an e n t e r p r i s e and.accompanying economic c o n d i t i o n s . I n c a l c u l a t i n g the d e p r e c i a t i o n ^ charge, a s y s t e m a t i c d e p r e c i a t i o n p o l i c y , . b a s e d on the p r o b a b l e h i s t o r y of the d e p r e c i a b l e a s s e t s , s h o u l d be adopted. I n p r a c t i c e , d i f f e r e n t d e p r e c i a t i o n methods are b e i n g f o l l o w e d . T h i s must be b o r n i n mind when comparing and e v a l u a t i n g companies i n terms of the r a t e of r e t u r n on investment. An i n t e r e s t charge s h o u l d be e x c luded from the net income f i g u r e used i n the r a t e o f r e t u r n measure; i t i s more l i k e a d i s t r i b u t i o n o f income than an o p e r a t i n g expense. The form of c a p i t a l s t r u c t u r e employed does not a f f e c t the c o s t of o p e r a t i n g an e n t e r p r i s e ; and i t i s the o p e r a t i n g e f f e c t i v e n e s s t h a t the r a t e o f r e t u r n on investment, as used i n t h i s paper, t r i e s t o measure and e v a l u a t e . 41 I n computing the r a t e of r e t u r n on shareholders' e q u i t y , the i n t e r e s t expense should be deducted from income; i n t h i s case, income a p p l i c a b l e to the shareholders' e q u i t y i s the r e s i d u a l amount a f t e r the payment of i n t e r e s t . Income taxes are o u t s i d e the c o n t r o l of management. The company's success or l a c k of success i n m i n i m i z i n g i t s income taxes does not r e f l e c t o p e r a t i n g e f f e c t i v e n e s s . Moreover, frequent changes i n tax r a t e s make comparisons over time d i f f i c u l t . Por these reasons the computation of net income f o r the purpose of e v a l u a t i n g company performance i n terms of the r a t e of r e t u r n on investment seems to be best before income t a x e s . Where the r a t e of r e t u r n i s based on shareholder's e q u i t y , income taxes are u s u a l l y deducted because what i s l e f t to the shareholders i s income a f t e r t a x e s . I I DEFINITIONS OF INCOME- FOR INTRA-GOMPANY COMPARISONS. J o e l Dean suggests three concepts of income, or p r o f i t as used by him, t h a t may be used i n measuring d i v i s i o n a l performance: a. Book net p r o f i t s b. R e a l net p r o f i t s c. C o n t r i b u t i o n p r o f i t s Book n e t " p r o f i t s t i e i n t o s t o c k h o l d e r r e p o r t s , have a s u r f a c e a c c e p t a b i l i t y and are not ve r y f u d g i b l e , but they e m b r o i l e x e c u t i v e s i n f r u i t l e s s debates about 42 a l l o c a t i o n of corporate overheads over which they have no c o n t r o l and r a i s e moot questions about c a p i t a l consumption cos t s of p l a n t a c q u i s i t i o n s at w i d e l y d i f f e r i n g p r i c e l e v e l s . R e a l net p r o f i t s may s e t t l e the l a t t e r questions ( i n f l a t i o n and d e p r e c i a t i o n ) but do not s e t t l e problems of a l l o c a t i o n of overhead beyond the d i v i s i o n manager's c o n t r o l . C o n t r i b u t i o n p r o f i t s have fewer of these drawbacks being c o n f i n e d to c o s t s and revenues over which the p r o f i t c e n t e r manager has c o n t r o l . ^ Because the purpose of the r a t e of r e t u r n on investment i s to measure, guide, and evaluate managerial performance, the assignment of r e s p o n s i b i l i t y f o r perform-ance must be coextensive w i t h a u t h o r i t y ; and a u t h o r i t y i m p l i e s c o n t r o l . No d i v i s i o n a l manager has any c o n t r o l over c e n t r a l l y a l l o c a t e d overheads, such as the remuneration of top e x e c u t i v e s or the expenses of the head o f f i c e . While recovery of company overheads i s important to top management, i t w i l l not be ensured by a l l o c a t i n g them to d i v i s i o n a l p r o f i t and l o s s statements. On the c o n t r a r y , such a l l o c a t i o n s impede e v a l u a t i o n of d i v i s i o n a l performance, because cos t s are a t t r i b u t e d to the d i v i s i o n s over which the d i v i s i o n s have no c o n t r o l and t h e r e f o r e are of no value i n g u i d i n g d i v i s i o n a l performance by p o i n t i n g areas needing a t t e n t i o n . Moreover, a r b i t r a r i n e s s of most a l l o c a t i n g systems impairs the v a l i d i t y of any e v a l u a t i o n of past and present performance, s i n c e good and bad years can be smoothed out by the way a l l o c a t i o n s f a l l . 1 J o e l Dean, " P r o f i t Performance Measurement of D i v i s i o n Manager," The C o n t r o l l e r , September, 1957. p. 426. 43 I n d e c e n t r a l i z e d o p e r a t i o n s , however, the d i v i s i o n manager has c o n t r o l over c o s t s and revenues o r i g i n a t i n g i n h i s d i v i s i o n . - These are u s u a l l y o p e r a t i n g c o s t s and oper-a t i n g revenue. Por these reasons c o n t r i b u t i o n income, i . e . , the income which emerges out of matching.of c o s t s and revenues over which the d i v i s i o n manager has c o n t r o l , seems to he the most a p p r o p r i a t e measure of d i v i s i o n a l management. The r a t e of r e t u r n on investment, when used as an i n t e r n a l managerial t o o l , need not he the same as t h a t used f o r e x t e r -n a l comparisons and e v a l u a t i o n . The c o n t r i b u t i o n income avoids a r b i t r a r i n e s s and p i t f a l l s a r i s i n g out of the a l l o c a t i o n of company overheads and, t h e r e f o r e , s u p p l i e s an a d d i t i o n a l reason why i t should be used i n e v a l u a t i n g d i v i s i o n a l performance i n terms of the r a t e of r e t u r n on investment. 44 CHAPTER VI PROBLEMS OP INVESTMENT DEFINITION I DEFINING INVESTMENT FOR INTER-COMPANY COMPARISONS I n p r a c t i c e , the investment base upon which r a t e of r e t u r n i s computed i s d e f i n e d i n v a r i o u s ways because d i f f e r e n t concepts of r a t e of r e t u r n are used f o r d i f f e r e n t purposes.. I n a p p r a i s i n g past r e s u l t s of the company as a whole, income may be r e l a t e d t o : 1. T o t a l assets a v a i l a b l e , i . e . , t o t a l a s s e t s appearing on the l e f t hand s i d e of the c o n v e n t i o n a l balance sheet. 2. T o t a l assets employed, i . e . , t o t a l a s s e t s a v a i l -able minus excess o r i d l e a s s e t s and other a s s e t s on which management i s not expected to earn a r e t u r n . To put i t i n another way, these are earnings a s s e t s , i . e . , asset value depends on who owns them as d i s -t i n g u i s h e d from defensive a s s e t s which have the same value no matter who owns them. 3. E q u i t y plus long-term debt. 4. T o t a l c a p i t a l employed by s t o c k h o l d e r s , i . e . , s t o c k h o l d e r s ' e q u i t y , g e n e r a l l y l i m i t e d to common stock e q u i t y . 45 .. A l l the company's resources are e n t r u s t e d to managerial c o n t r o l . To measure managerial performance th e r e f o r e , , i t seems l o g i c a l to use t o t a l a s s e t s a v a i l a b l e as an investment base. The r a t e of r e t u r n on.investment computed on any .of the other three investment bases, w i l l r e f l e c t managerial e f f e c t i v e n e s s o n l y p a r t i a l l y . The t o t a l a s s e t s a v a i l a b l e f i g u r e i s a l s o c o n s i s t e n t w i t h the d e f i n i t i o n of income as.-developed i n the previous chapter. An a d d i t i o n a l reason f o r u s i n g t o t a l a s s e t s as an investment b a s e . i s t h a t the f i g u r e s are p u b l i c l y a v a i l a b l e and, t h e r e f o r e , can be-r e a d i l y used i n inter-company comparisons. Companies which use t o t a l a s s e t s employed as the investment base, e l i m i n a t e the as s e t s which are not expected to earn a r e t u r n . Some exclude cash; others exclude con-s t r u c t i o n i n progress or other assets, which are h e l d w i t h a view t o . o t h e r o b j e c t i v e s than the s h o r t - r u n maximization of p r o f i t s . . I d e a l l y , a l l e n t e r p r i s e a s s e t s should be earning a s s e t s . This i s not always p o s s i b l e , C e r t a i n . i n v e s t m e n t s , f o r example c o n s t r u c t i o n i n progr e s s , do not b r i n g any i n -come u n t i l the beginning of o p e r a t i o n s . However,,all defen-s i v e a s s e t s should r e s u l t . i n the long-run p r o f i t s , otherwise managerial d e c i s i o n s to ac q u i r e and h o l d such a s s e t s make l i t t l e sense. Since managerial e f f e c t i v e n e s s i s r e f l e c t e d i n income a r i s i n g out of a l l the e n t e r p r i s e a s s e t s , the use of t o t a l a s s e t s a v a i l a b l e r a t h e r than t o t a l a s s e t s employed seems to be a b e t t e r investment base f o r the purpose of 46 company and m a n a g e r i a l e v a l u a t i o n . The e x i s t e n c e of d e f e n s i v e a s s e t s may lower the r a t e of r e t u r n on t o t a l a s s e t s a v a i l a b l e ; the e f f e c t of d e f e n s i v e a s s e t s on the r a t e o f r e t u r n on investment may, however, he a l l o w e d f o r when a p p r a i s i n g the o v e r a l l company performance. Companies t h a t use e q u i t y p l u s . l o n g - t e r m debt as t h e i r .investment base r e a s o n t h a t , s i n c e c u r r e n t l i a b i l i t i e s are temporary i n n a t u r e , management s h o u l d not be expected to earn.a r e t u r n on a s s e t s s u p p l i e d by s h o r t - t e r m c r e d i t o r s . T h i s is,however, not a sound argument. In the f i r s t p l a c e , i t i s v e r y d i f f i c u l t and sometimes i m p o s s i b l e to e x t r i c a t e a s s e t s purchased w i t h s h o r t and l o n g-term f u n d s ; s e c o n d l y , management i s r e s p o n s i b l e f o r e f f e c t i v e . u t i l i z a t i o n of a s s e t s no matter.who s u p p l i e d the money to purchase.them o r even when no money was expended i n t h e i r a c q u i s i t i o n , such as donated a s s e t s . The r a t e of r e t u r n on s h a r e h o l d e r s ' e q u i t y i s used where the purpose i s to measure r a t e of r e t u r n earned on the amount.of s h a r e h o l d e r s • c a p i t a l employed i n the b u s i n e s s . I t i s o f c o n s i d e r a b l e i n t e r e s t to f i n a n c i a l management and takes the s h a r e h o l d e r ' s or o u t s i d e i n v e s t o r ' s v i e w p o i n t . I t i s adopted where the c a p i t a l s t o c k i s c l o s e l y h e l d and s h a r e -h o l d e r s e v a l u a t e management i n terms of i t s a b i l i t y to improve the p o s i t i o n of s h a r e h o l d e r s . I n d i s c u s s i n g a d e f i n i t i o n o f investment i n the r a t e 47 of r e t u r n on investment f o r m u l a , the N.A.A. Research R e p o r t 35 says t h a t : Some companies i n t e r v i e w e d were found to he u s i n g more than one investment base. These companies use r a t e o f r e t u r n f o r more than one.purpose and t h e r e f o r e d e f i n e c a p i t a l so t h a t the r e s u l t i n g r a t e s o f r e t u r n w i l l be r e l e v a n t to the in t e n d e d purposes. Other companies use a v a r i e t y o f investment bases on o c c a s s i o n , but one b a s i s as a r e g u l a r , and major t o o l of e v a l u a t i o n . Thus, i n making a comparison between t h e i r company and c o m p e t i t o r s , they sometimes r e v i s e t h e i r investment base to conform w i t h the f i g u r e s which are p u b l i c l y a v a i l a b l e . 1 I n i n t e r n a l performance measurement the u s e r o f c a p i t a l , i . e . , management, r a t h e r than the s u p p l i e r i s the key f i g u r e . T o t a l a v a i l a b l e a s s e t s are p l a c e d a t manage-ment's d i s p o s a l ; t o t a l a s s e t s , t h e r e f o r e , seem to be the bes t " i n v e s t m e n t base to be used i n m a n a g e r i a l performance a p p r a i s a l . I n some cas e s , c e r t a i n , r e s o u r c e s , such as p a t e n t s , t r a d e marks, and l e a s e d a s s e t s , a re o m i t t e d from the balance s h e e t . I n o t h e r cases, i t i s d i f f i c u l t to put an o b j e c t i v e v a l u e on i n t a n g i b l e a s s e t s , g o o d w i l l , p a t e n t s , t r a d e marks, e t c . The e x i s t e n c e o f such a s s e t s i s g e n e r a l l y r e f l e c t e d i n a h i g h e r r a t e of r e t u r n t han i t would be i n the absence o f such a s s e t s . T h i s s h o u l d be c o n s i d e r e d i n comparing inter-company performance. 1 R e t u r n on Capital.' as a Guide to M a n a g e r i a l D e c i s i o n s ( N i A . A . Research Report 35, 1959), p.9. 48 Leased a s s e t s do not u s u a l l y appear on the balance sheet. When such.assets have a m a t e r i a l . e f f e c t on income, they should be i n c l u d e d i n investment base, otherwise the r a t e s of r e t u r n on investment cease to be .comparable. Often, l e a s e arrangements represent a form of borrowing. I n these cases, i n t e r e s t f a c t o r imputed i n r e n t a l payments i s c a p i t -a l i z e d by some companies and i n c l u d e d i n the investment base. The d i f f e r e n c e between the t o t a l r e n t payable and imputed i n t e r s t i s charged as an expense of the p e r i o d . I t i s f a i r l y obvious t h a t i n businesses where human resources are the major source of e a r n i n g s , . f o r example i n e n t e r p r i s e s r e n d e r i n g p r o f e s s i o n a l s e r v i c e s , a p p r a i s a l of management i n terms of the r a t e of r e t u r n on investment has l i t t l e meaning. I I DEFINING THE INVESTMENT CHARGED TO DIVISIONS The d e f i n i t i o n of d i v i s i o n a l . i n v e s t m e n t should be c o n s i s t e n t w i t h the d e f i n i t i o n of income. Only the as s e t s f o r which d i v i s i o n a l manager i s r e s p o n s i b l e and over which he has c o n t r o l w i l l e f f e c t i v e l y r e f l e c t h i s performance. In a d d i t i o n , the c o n d i t i o n s l i s t e d i n Chapter.IV concerning d i v i s i o n a l boundaries, t r a n s f e r p r i c i n g , e t c . , must be f u l -f i l l e d . The d i v i s i o n was de f i n e d e a r l i e r as a u n i t to which both, income and investment are a t t r i b u t a b l e . This a p p l i e s l a r g e l y to d e c e n t r a l i z e d companies o p e r a t i n g on semi-autonomous b a s i s . Even here, there i s a problem of what 49 a s s e t s to i n c l u d e and what asset s to exclude or how to a l l o c a t e f a c i l i t i e s which are shared i n common by two or more d i v i s i o n s . The main c r i t e r i o n should be: has the d i v i s i o n a l manager c o n t r o l over the a s s e t ? Can he, i n other words, use the asset i n any way to a t t a i n the d e s i r e d o b j e c t i v e s without r e s t r i c t i o n s o r c o n s t r a i n t from the top management. I f so, the asset should be i n c l u d e d i n the investment base; i f not, i t should.be excluded from the investment of the p a r t i c u l a r d i v i s i o n , otherwise top management i s e v a l u a t i n g i t s e l f . A l l o c a t i o n of common f a c i l i t i e s on a r b i t r a r y b a s i s , as i s the case i n p r a c t i c e , and i n c l u s i o n of such f a c i l i t i e s i n the r e t u r n on investment c a l c u l a t i o n s does not r e f l e c t the d i v i s i o n a l manager's e f f e c t i v e n e s s . Although t h e . d i v i s i o n a l manager may be r e s p o n s i b l e f o r the use of such f a c i l i t i e s , he has no c o n t r o l over them. Such a r b i t r a r y a l l o c a t i o n s should be avoided. The problem can be s o l v e d by p l a c i n g such f a c i l i t i e s under the j u r i s d i c t i o n of a separate head, or by p l a c i n g them under the c o n t r o l of a major user and e s t a b l i s h i n g , at the same time, sound p r i c i n g of s e r v i c e s rendered by the f a c i l i t i e s to d i f f e r e n t d i v i s i o n s . I n many cases even when f a c i l i t i e s are l a r g e l y d e c e n t r a l i z e d , a s s e t s l i k e r e c e i v a b l e s and cash are common-l y c e n t r a l i z e d . Some companies i n c l u d e cash; some exclude i t . Some e s t a b l i s h a c e r t a i n minimum cash requirements*. Whether to i n c l u d e or exclude cash from d i v i s i o n a l investment base 50 w i l l depend on.-whether d i v i s i o n manager has c o n t r o l over cash. U s u a l l y , the c o n t r o l of cash i s i n the hands of top management; the cash resources are pooled.from a l l segments of the company and adm i n i s t e r e d c e n t r a l l y . I n these circum-s t a n c e s , cash should not he i n c l u d e d i n d i v i s i o n a l -investment base. S i m i l a r l y w i t h accounts r e c e i v a b l e . Some companies i n c l u d e a c t u a l f i g u r e s . Some companies i n c l u d e them by-an a r b i t r a r y f o r m u l a ; others exclude them. When the d i v i s i o n manager can.change the terms of s a l e and i s r e s p o n s i b l e f o r the c o l l e c t i o n of accounts r e c e i v a b l e , i n c l u s i o n of the a c t u a l f i g u r e f o r accounts r e c e i v a b l e i n a d i v i s i o n ' s investment base makes any chages i n terms of c o l l e c t i b i l i t y of accounts r e f l e c t e d i n the d i v i s i o n a l performance. Under these circumstances accounts r e c e i v a b l e should be i n c l u d e d . However, W i l l i a m Rotch found t h a t investment i n accounts r e c e i v a b l e and cash was con-s i d e r e d by the top management to be an i n f l e x i b l e p r e r e -q u i s i t e of business and a p a r t of top management f i n a n c i a l p o l i c y . 1 Inventory i s u s u a l l y i n c l u d e d i n the investment base. D i v i s i o n manager i s u s u a l l y r e s p o n s i b l e f o r o p e r a t -i o n and.sales.of h i s d i v i s i o n , and i n v e n t o r y is.under h i s c o n t r o l . I t c o n s t i t u t e s a b u f f e r between p r o d u c t i o n and s a l e s . There' are a number of d i f f e r e n t ways of valuing. .- : in v e n t o r y , e.g., " l a s t - i n , f i r s t - o u t " (goods purchased 1 W i l l i a m Rotch, "Return on Investment as a Measure of Performance" (Unpublished Doctor's D i s s e r t a t i o n , Harvard U n i v e r s i t y , 1958), pp. 118-119. 51 l a s t a r e s o l d f i r s t ) , ' " f i r s t - i n , f i r s t - o u t " (goods bought f i r s t are d i s p o s e d f i r s t ) , lower of c o s t o r market, e t c . , and when comparing d i f f e r e n t companies and d i v i s i o n s i t i s important to r e c o g n i z e these d i f f e r e n c e s . In times of r i s i n g p r i c e s , " f i r s t - i n , f i r s t - o u t " method of i n v e n t o r y . v a l u a t i o n w i l l produce more c u r r e n t v a l u e s t han " l a s t - i n , f i r s t - o u t " method. T h i s i s more important i n comparing d i f f e r e n t companies than i n comparing v a r i o u s d i v i s i o n s i n the same company, where the same method of v a l u i n g i n v e n t o r y i s most l i k e l y to be used throughout the e n t i r e company. F i x e d a s s e t s are u s u a l l y under d i r e c t c o n t r o l o f d i v i s i o n manager and s h o u l d be i n c l u d e d i n h i s i n v e s t -ment base. As s t a t e d b e f o r e , however, d i v i s i o n manager s h o u l d not be h e l d r e s p o n s i b l e f o r d e c i s i o n s made b e f o r e he took.over, which cannot be changed i n s h o r t o r d e r . F o r e xample,-if a p l a n t has been c l o s e d down but not d i s p o s e d o f , the d i v i s i o n manager s h o u l d be r e l i e v e d o f r e s p o n s i b i l i t y f o r the amount o f c a p i t a l i n v e s t e d i n the a s s e t s of t h i s c l o s e d down p l a n t , u n l e s s o r . u n t i l he i s p e r m i t t e d to r e v i s e the p r e v i o u s d e c i s i o n , o therwise the r a t e of r e t u r n on investment used i n e v a l u a t i n g m a n a g e r i a l performance has l i t t l e meaning. The problem of g r o s s or net f i x e d a s s e t s a p p l i c a b l e to both company and d i v i s i o n s i s t r e a t e d i n subsequent paragraphs. 52 I I I ALLOCATION OF ASSETS TO DIVISIONS The problem of a l l o c a t i o n of assets to d i v i s i o n s was touched upon i n the preceding s e c t i o n d e a l i n g w i t h the d e f i n i t i o n of d i v i s i o n a l investment. This s e c t i o n deals w i t h the a l l o c a t i o n of c e n t r a l l y administered a s s e t s and co s t s to d i v i s i o n s . The d i f f i c u l t y i n a l l o c a t i o n s l i e s not so,much i n the t a s k of t r a c i n g c e n t r a l l y . a d m i n i s t e r e d a s s e t s , although t h i s may be a hard assignment, as i n the i n a b i l i t y of the d i v i s i o n manager to c o n t r o l such ass e t balances. I f these asset balances are s u b s t a n t i a l i n r e l a t i o n to the t o t a l d i v i s i o n a l investment base, the r a t e of r e t u r n on investment which i n c l u d e s such asset s i s a poor r e f l e c t i o n of the d i v i s i o n manager's performance. Most of the commonly used a l l o c a t i o n methods a s s i g n c e n t r a l l y a d m i n i s t e r e d c u r r e n t a s s e t s , such as. cash, i n v e n t -o r i e s , or accounts r e c e i v a b l e , on some a r b i t r a r y index of d i v i s i o n a l a c t i v i t y , e.g.,.a r a t i o to s a l e s or a r a t i o to p r o d u c t i o n . These methods, however, assume a p r o p o r t i o n -a l i t y between asset balances and a c t i v i t y t h a t , i n f a c t , may not e x i s t . An in c r e a s e i n s a l e s , f o r example, may be achieved w i t h l e s s than p r o p o r t i o n a l i n c r e a s e i n i n v e n t o r -i e s . I f s a l e s d e c l i n e r a p i d l y and p r o d u c t i o n continues at the same r a t e , more than p r o p o r t i o n a l accumulation of i n -ventory balances may r e s u l t . 53 This problem may be solved, by c h a r g i n g to a d i v i s i o n the a c t u a l amounts of any c e n t r a l l y a d m i n i s t e r e d a s s e t s t h a t can be t r a c e d to t h a t d i v i s i o n , p r o v i d e d the d i v i s i o n a l manager can c o n t r o l such a s s e t s . Por example, i f i n v e n t o r y balances c o n t r o l i s a d i v i s i o n a l r e s p o n s i b -i l i t y then any changes i n i n v e n t o r y l e v e l s should be r e f l e c t -ed i n the r a t e of r e t u r n on investment. On the other hand, i f i n v e n t o r y l e v e l s are c o n t r o l l e d by the head o f f i c e , f l u c t u a t i o n s i n i n v e n t o r i e s should not be r e f l e c t e d i n the investment base of the d i v i s i o n . • Any c e n t r a l l y a d m i n i s t e r e d a s s e t s t h a t cannot be t r a c e d to d i v i s i o n s or are not s u b j e c t to c o n t r o l by the d i v i s i o n managers should be l e f t out pf the d i v i s i o n a l investment base a l t o g e t h e r ; otherwise, t h e . e v a l u a t i o n of the d i v i s i o n managers' performance i s apt to be m i s l e a d i n g . I f a l l o c a t i o n s are made i n order to review h i s t o r i c a l p r o f i t a b i l i t y of the d i v i s i o n s e p a r a t e l y from, the performance of the manager, the r e s u l t i n g r a t e of r e t u r n on investment should not be used i n a p p r a i s i n g d i v i s i o n a l management. I n f a c t , two r a t e s of r e t u r n on two d i f f e r e n t investment bases should be c a l c u l a t e d : one f o r e v a l u a t i n g the d i v i s i o n as a u n i t , the other f o r a p p r a i s i n g the d i v i s i o n a l manager's performance. The a l l o c a t i o n s of c e n t r a l l y a d m i n i s t e r e d a s s e t s to measure the p r o f i t a b i l i t y of the d i v i s i o n as a u n i t can be done a c c o r d i n g to some budget formula. I n e f f e c t , no d i s t o r t i o n of the managerial performance e v a l u a t i o n would r e s u l t . Oommon c o s t s which are i n c u r r e d to enable a l l 54 d i v i s i o n s to c a r r y out t h e i r operations can o n l y he a l l o c a t e d on a r b i t r a r y b a s i s . These c o s t s would not be d i f f e r e n t even i f the d i v i s i o n c l o s e d down. Therefore, mere a l l o c a t i o n of such c o s t s has no relevance i n a s c e r t a i n i n g the l e v e l of d i v i s i o n a l management performance and no a i d i n . d e t e r m i n i n g the r e l a t i v e performance of d i f f e r e n t d i v i s i o n s . Common cos t s are, u s u a l l y , a l l o c a t e d on one of the two bases: 1. As a predetermined lump sum, i f c o s t s are u n a f f e c t e d e i t h e r by the volume of a c t i v i t y i n the d i v i s i o n or by the d i v i s i o n a l demand f o r s e r v i c e s . 2. At a predetermined r a t e o r . p r i c e times index of a c t i v i t y or demand f o r s e r v i c e s i n the d i v i s i o n . Predermined lump sum assumes no c o n t r o l l a b i l i t y . The a p p l i c a t i o n of the predetermined r a t e presumes c o n t r o l l a b i l i t y over q u a n t i t i e s but none over p r i c e s per u n i t of q u a n t i t y . N e i t h e r the f i r s t nor the second seems to be a good s o l u t i o n . What i s wanted i s the d i v i s i o n a l income f i g u r e which adequat-e l y r e f l e c t s the degree of c o n t r o l t h a t the d i v i s i o n manager i s able to e x e r t . This can o n l y happen i f the d i v i s i o n manager has c o n t r o l both over p r i c e s and q u a n t i t i e s . Where these c o n d i t i o n s p r e v a i l , i t i s b e t t e r to charge c e n t r a l c o s t s d i r e c t l y t o the d i v i s i o n r a t h e r than use a r b i t r a r y a l l o c a t i o n s . IV PIXED ASSETS Background. P i x e d a s s e t s c o n s t i t u t e , u s u a l l y , the 55 most s i g n i f i c a n t item i n most companies u s i n g the r a t e of r e t u r n on investment i n e v a l u a t i n g managerial performance. F i x e d a s s e t s loom l a r g e i n the l i t e r a t u r e on the rate, of r e t u r n on investment., The f i x e d asset i s d e f i n e d hy K o h l e r as: A t a n g i b l e asset h e l d f o r the s e r v i c e s i t y i e l d s i n the p r o d u c t i o n of other goods and s e r v i c e s ; any item of p l a n t . ^ The g r e a t e s t problem a r i s e s . i n how to t r e a t f i x e d a s s e t s i n the investment base, i . e . , use of gross f i x e d a s s e t s or f i x e d a s s e t s net of accumulated d e p r e c i a t i o n . The d i f f e r e n c e between gross and net f i x e d , a s s e t s a r i s e s then from the treatment of accumulated d e p r e c i a t i o n which i s deducted from the o r i g i n a l cost to a r r i v e a t net f i x e d a s s e t s . There are a l s o v a l u a t i o n accounts f o r a s s e t s other than f i x e d , such as an allowance f o r bad •debts',: an allowance f o r i n v e n t o r y l o s s e s , e t c . , and the q u e s t i o n a l s o e x i s t i n the v a l u a t i o n of other a s s e t s . Since the other v a l u a t i o n accounts are much s m a l l e r . t h a n the.accumulated d e p r e c i a t i o n allowance on f i x e d a s s e t s , the d i s c u s s i o n w i l l be c o n f i n e d to the h a n d l i n g of accumulated d e p r e c i a t i o n allowance. Before proceeding to d i s c u s s t h i s s u b j e c t , however, i t i s important to c o n s i d e r what i s meant by an asset and - - to see what d i s t i n g u i s h e s an asset from an expense, s i n c e ~ 1 Ws E r i e I . K o h l e r , A D i c t i o n a r y f o r Accountants (New York: P r e n t i c e - H a l l , 1953), p. 179* 56 assignment of cos t to one or other category may a f f e c t s i g n i f i c a n t l y the r a t e of r e t u r n on investment. F i r s t of a l l there i s no unanimity i n p r a c t i c e as to what i s meant by a s s e t s . The amount of as s e t s shown i n any f i n a n c i a l statement depends i n p a r t upon the a t t i t u d e t h a t i s taken w i t h r e g a r d to " c a p t i a l versus revenue" exp e n d i t u r e s . The d i s t i n c t i o n between c a p i t a l and revenue i s fundamental to most accounting procedures, though the nature of the d i s t -i n c t i o n i s not always made c l e a r by the taxtbooks. I t i s o f t e n s a i d f o r i n s t a n c e , t h a t c a p i t a l expenditure i s t h a t expenditure which r e s u l t s i n the a c q u i s i t i o n , of an a s s e t . But i t might be s a i d t h a t an asset i s what r e s u l t s from c a p i t a l expenditure. This b r i n g s us back to the problem of d e f i n i n g an a s s e t . Besides, even i f common parlance i s ac c -epted f o r the moment, i t might be s a i d t h a t . a l l expenditure r e s u l t s i n the a c q u i s i t i o n of an a s s e t . — t w e n t y - f i v e cents spent on a b o t t l e of i n k , f o r i n s t a n c e . B o t t l e s of i n k are not c a p i t a l i z e d ; they are w r i t t e n o f f as p a r t of the c o s t of " p r i n t i n g and s t a t i o n a r y . " But i f a gross of b o t t l e s were bought, the unused s t o c k might p o s s i b l y be c a r r i e d forward at the end of the p e r i o d as an asse t i n the balance sheet. This should help to make c l e a r what d i s t i n c t i o n between c a p i t a l and revenue expenditure r e a l l y , i s . C a p i t a l expend-i t u r e i s expenditure the d i r e c t b e n e f i t s of which are to be r e c e i v e d i n f u t u r e accounting p e r i o d s . Thus i t i s not o n l y the nature of the expenditure but the l e n g t h of the account-i n g p e r i o d which i s m a t e r i a l . Thus a year's r e n t p a i d i n advance on January 1 i s w h o l l y a charge to"revenue i n an 57 account prepared f o r the year ended on the f o l l o w i n g December 3 1 ; but i n an account ending on June 3 0 , o n l y h a l f the amount i s revenue expenditure, and h a l f i s c a r r i e d f o r -ward as c a p i t a l expenditure. This d i s t i n c t i o n i s s i g n i f i c a n t i n the r a t e of r e t u r n on investment c a l c u l a t i o n s . For example, if. a $ 1 , 0 0 0 item i s charged as revenue expense i n s t e a d of being t r e a t e d as a c a p i t a l a d d i t i o n , i t reduces income but leaves the investment base u n a f f e c t e d . I f t h i s item i s . t r e a t e d as an asset a d d i t i o n , the income would not be reduced, but the investment base would be i n c r e a s e d . Then, i f the income had been $ 5 , 0 0 0 on a $ 1 0 0 , 0 0 0 base without i n c l u d i n g the $ 1 , 0 0 0 charge, t r e a t i n g $ 1 , 0 0 0 as a revenue expenditure produces 4 per cent r e t u r n on investment. I f on the other hand, $ 1 , 0 0 0 . i s c a p i t a l i z e d , the investment base i n c r e a s e s to $ 1 0 1 , 0 0 0 , on which a $ 5 , 0 0 0 r e t u r n i s 4 . 9 5 per. cent. These f l u c t a t i o n s i n the r a t e of r e t u r n are ma g n i f i e d because such items, though s m a l l i n r e l a t i o n to s a l e s or a s s e t s , are l a r g e i n r e l a t i o n to net income f i g u r e . Choice of gross or net f i x e d a s s e t s . I n the March 1958 i s s u e of N.A.A. B u l l e t i n , the f o l l o w i n g arguments were used i n favour of the gross f i g u r e f o r f i x e d a s s e t s : 1. I t provides some e q u a l i z a t i o n of f a c i l i t y v alues of the d i f f e r e n t d i v i s i o n s or companies, e s p e c i a l l y between those w i t h o l d p l a n t s b u i l t at r e l a t i v e l y low cos t and those w i t h new p l a n t s b u i l t at hi g h c o s t . 2. Assets of manufacturing companies, u n l i k e mining companies, are considered to be on a c o n t i n u i n g 58 "basis r a t h e r than depleted and abandoned. 3. Gross asset s of one p l a n t can be compared w i t h those of another p l a n t where d e p r e c i a t i o n p r a c t i c e s may be d i f f e r e n t . 4. Reserve f o r d e p r e c i a t i o n i s not deducted from the gross asset value of p r o p e r t y , s i n c e i t r e p r e s e n t s the r e t e n t i o n i n business of the funds r e q u i r e d to keep i n t a c t the o r i g i n a l investment by s t o c k h o l d e r s . A c t u a l l y the f i x e d a s s e t s are used to produce net income du r i n g t h e i r e n t i r e l i f e and, t h e r e f o r e , f u l l c ost value i s considered a s o r t of investment u n t i l the a s s e t s are r e t i r e d from use. 5. A deduction f o r l i a b i l i t i e s and r e s e r v e s from the amount i n v e s t e d i n o p e r a t i n g p r o p e r t i e s would show a f l u c t u a t i o n i n o p e r a t i n g investment due to growth of r e s e r v e s and change i n amount of s t o c k h o l d e r c a p i t a l which, i n t u r n , would produce such a d i s t o r t i o n i n the r e t u r n on investment as to render i t meaningless... The f o l l o w i n g reasons were advanced f o r the use of net a s s e t s : 1 . While i n v e s t e d c a p i t a l i s c o n v e n t i o n a l l y under-s t a t e d at the present time, the wrong method of i n -c r e a s i n g i t cannot be r e l i e d on to f u r n i s h the r i g h t r e s u l t s and the attempt can o n l y add to the e x i s t i n g c o n f u s i o n i n accounting t h i n k i n g . Gash b u i l t up v i a a d e p r e c i a t i o n r e s e r v e , i f added to the gross a s s e t s , amounts to o v e r s t a t i n g the investment. 2. F i x e d a s s e t s are shown at net d e p r e c i a t e d v a l u e s thus a v o i d i n g d u p l i c a t i o n of asset v a l u e s . 3. An investment i s something separate and d i s t i n c t from the media through which i t was made. The purchase 1 Some V a r i a t i o n s i n C a n s t r u e t i o n and Use of• Return on Investment (N.A.A. B u l l e t i n , March, 19587, pp.25-2o"7 59 p r i c e of a machine should he regarded as the p r e p a i d co s t f o r the number of years of p r o d u c t i o n expected. I t s v a l u e , and hence the l i m i t s to i t s investment s t a t u s at any time t h e r e a f t e r , w i l l depend not on i t s c u r r e n t mechanical e f f i c i e n c y hut oh the number of years of f u t u r e p r o d u c t i o n i t can promise. Each year t h i s number w i l l d e c l i n e and the d e c l i n e should be o f f -s e t by cash w i t h h e l d from gross revenues. The f u n c t i o n of d e p r e c i a t i o n accounting i s to main-t a i n the aggregate i n v e s t e d c a p i t a l by p r o v i d i n g sub-s t i t u t e a s s e t s c u r r e n t l y ( o r i g i n a l l y cash from revenues) to r e p l a c e the aggregate asset consumption ( d e p r e c i a t i o n ) of the year... These arguments f a l l i n t o three eatagor.ies: ( 1 ) E n s u r i n g c o m p a r a b i l i t y of one d i v i s i o n w i t h another or one company w i t h another; (2) establishment of a " t r u e " r a t e of r e t u r n ; (3) r e f l e c t i o n of changes i n t h e . r a t e of r e t u r n by changes i n managerial performance. Inter-company and intra-company comparisons. Arguments (1 ) and (3) f o r the use of gross a s s e t s and a r g -ument ( 1 ) f o r the use of net asset s are i n favour of e s t -a b l i s h i n g investment base which w i l l be comparable from d i v i s i o n to d i v i s i o n and between companies. The arguments f o r gross a s s e t s a r e : 1 I b i d . , p. 26. 60 1. I t p r o v i d e s some e q u a l i z a t i o n o f f a c i l i t y -v a l u e s o f d i f f e r e n t d i v i s i o n s o r companies, e s p e c i a l l y between those w i t h o l d p l a n t s b u i l t a t r e l a t i v e l y low c o s t and those w i t h new p l a n t s b u i l t a t h i g h c o s t . 3. Gross a s s e t s o f one p l a n t can be compared w i t h those of another p l a n t where d e p r e c i a t i o n p r a c t i c e s may be d i f f e r e n t . The argument f o r net a s s e t s s e e k i n g the same r e s u l t i s : 1. While i n v e s t e d c a p i t a l i s c o n v e n t i o n a l l y under-s t a t e d a t the p r e s e n t time, the wrong method i f i n -c r e a s i n g i t cannot be r e l i e d on to f u r n i s h the r i g h t r e s u l t s and the attempt can only' a d d to the e x i s t i n g c o n f u s i o n i n a c c o u n t i n g t h i n k i n g . Cash b u i l t up v i a a d e p r e c i a t i o n r e s e r v e , i f added t o the g r o s s a s s e t s , amounts to o v e r s t a t i n g the investment. The arguments f o r g r o s s a s s e t s say i n e f f e c t t h a t i n o r d e r t o compare two companies o r . d i v i s i o n s , the i n v e s t -ment bases s h o u l d be comparable. O r i g i n a l . c o s t i s advocated to reduce the e f f e c t o f i n f l a t i o n and d i s t o r t i o n s due t o d i f f e r e n t d e p r e c i a t i o n methods. The argument:: f o r net a s s e t s a l s o aims a t compar-a b i l i t y o f investment bases, but says t h a t t h i s cannot be accomplished by the use o f o r i g i n a l c o s t . I t i s d e s i r a b l e to have v a l u a t i o n bases comparable between companies and d i v i s i o n s , but i t i s d o u b t f u l whether such c o m p a r a b i l i t y can be a c h i e v e d by the use of g r o s s a s s e t s . E l i m i n a t i n g d e p r e c i a t i o n from c o n s i d e r a t i o n does not s o l v e the problem but o n l y adds c o n f u s i o n . What i s needed i s the' 61 c u r r e n t v a l u a t i o n of a s s e t s r a t h e r t han a r t i f i c a l smoothing o f f l u c t u a t i o n s i n p r i c e l e v e l s hy i g n o r i n g the f a c t s and a c c e p t i n g a f a r - f e t c h e d f i g u r e o f g r o s s a s s e t s . The o r i g i n a l c o s t was the c o r r e c t a s s e t v a l u e at the time of p u r c h a s e . With the passage of time, t h e r e i s a growing d i s p a r i t y be-tween the o r i g i n a l c o s t and the c u r r e n t a s s e t v a l u e . The t h i r d argument, a l t h o u g h r i g h t i n c r i t i c i z i n g , g r o s s a s s e t s b a s i s of v a l u a t i o n , i s wrong i n s t a t i n g t h a t , "Cash b u i l t - u p v i a a d e p r e c i a t i o n r e s e r v e , i f added.to the g r o s s a s s e t s , amounts to o v e r s t a t i n g the investment." T h i s i s m i s a p p l i c a t i o n of a c c o u n t i n g i d e a s . Cash i s c e r t a i n l y not b u i l t up to await the replacement o f ; d e p r e c i a t e d a s s e t ; i t i s i n v e s t e d i n o t h e r a s s e t s . C u r r e n t r a t e of r e t u r n . E s t a b l i s h m e n t of some k i n d of '.'true" r a t e of r e t u r n i s sought by arguments ( 2 ) and ( 4 ) f o r the use o f g r o s s a s s e t s and argument (3 ) f o r net a s s e t s . The arguments f o r g r o s s a s s e t s a r e : 2. A s s e t s of m a n u f a c t u r i n g companies, u n l i k e m i n i n g companies, are c o n s i d e r e d to-be on a c o n t i n u i n g b a s i s r a t h e r t han d e p l e t e d and abandoned. 4 . Reserve f o r d e p r e c i a t i o n i s not deducted from the g r o s s a s s e t v a l u e o f p r o p e r t y , s i n c e i t r e p r e s e n t s the r e t e n t i o n i n b u s i n e s s of the funds r e q u i r e d to keep i n t a c t the o r i g i n a l investment by s t o c k h o l d e r s . A c t u a l l y the f i x e d a s s e t s are used to produce net income d u r i n g t h e i r e n t i r e l i f e and, t h e r e f o r e , f u l l c o s t v a l u e i s c o n s i d e r e d a s o r t o f investment u n t i l the a s s e t s are r e t i r e d from us e . 62 The argument f o r net asset v a l u a t i o n aiming at a " t r u e " r a t e of r e t u r n i s : 3. An investment i s something' separate and d i s t i n c t from the media through which i s was made. The purchase p r i c e of a machine should he regarded as the p r e p a i d co s t f o r a number of years of p r o d u c t i o n expected. I t s v a l u e , and hence the l i m i t to i t s investment s t a t u s at any time t h e r e a f t e r , w i l l depend not on i t s c u r r e n t mechanical e f f i c i e n c y but the number of years of f u t u r e p r o d u c t i o n i t can promise. Each year t h i s number w i l l d e c l i n e and the d e c l i n e should be o f f s e t by cash w i t h h e l d from gross revenue. The f u n c t i o n of d e p r e c i a t i o n accounting i s t o main-t a i n the aggregate i n v e s t e d c a p i t a l by" p r o v i d i n g s u b s t i t u t e assets c u r r e n t l y ( o r i g i n a l l y cash from revenues) to r e p l a c e the aggregate asset consumption ( d e p r e c i a t i o n ) of the y e a r . The arguments imply t h a t a t r u e r a t e of r e t u r n can be a r r i v e d at by computing i t from a c e r t a i n standard which i s maintenance of o r i g i n a l c a p i t a l i n t a c t . T h i s i s s i m i l a r to the economic concept of income which i s expressed as the maximum amount t h a t c o u l d be consumed and s t i l l leave the i n d i v i d u a l or e n t i t y as v / e l l off at the end of the p e r i o d as at the beginning. I t i s , i m p o r t a n t f o r the measure to be a c c u r a t e ; t h i s accuracy, however, i s achieved by n e i t h e r a r a t i o of income to gross a s s e t s nor to net a s s e t s . N e i t h e r accounts f o r : ( 1 ) Income d e r i v e d from r e i n v e s t e d funds recovered through d e p r e c i a t i o n charges. 63 (2) .Timing and shape of earnings r e c e i v e d or to he r e c e i v e d from c u r r e n t investment. (3) Changes i n p r i c e l e v e l s . The above three f a c t o r s can be accounted f o r by •estimating-the time curve of f u t u r e gross r e c e i p t s of a business and f u t u r e gross payments and d i s c o u n t i n g them to the pre s e n t . This i n v o l v e s , however, choice of appro-p r i a t e discount r a t e and f o r e c a s t i n g of revenues and expenditures. T h e o r e t i c a l l y , t h i s view has much to commend i t . P r a c t i c a l l y , i t i s not f e a s i b l e . I n the words of George 0. May: ... to accept a ' d i s c o u n t i n g of the f u t u r e 1 method of implementing the-concept would be w h o l l y unacceptable to them; f i r s t , because i t would i n v o l v e counting chickens before they are hatched; and secondly because i t contemplates the use of estimates and discount r a t e s t h a t n e c e s s a r i l y are s u b j e c t i v e , c o n j e n c t u r a l , and u n v e r i f i a b l e . ^ The t h i r d argument needs a s p e c i a l comment as i t leads to c o n f u s i o n of accounting concepts. D e p r e c i a t i o n i s confused here w i t h f i n a n c i n g of replacement. B a s i c purpose of a c c r u i n g d e p r e c i a t i o n i s conceived by t h i s argument.as accumulation of funds to provide f o r the renewal of the a s s e t s . At best, t h i s i n o n l y h a l f - t r u t h which may l e a d to erroneous c o n c l u s i o n s . The r e a l purpose of deprec-i a t i o n i s matching of p e r i o d i c c o s t s and revenues. George 0. May, "Concepts of Business Income and Th e i r Implementation," The Q u a r t e r l y J o u r n a l of Economics, February, 1954, p.3. -64 As s t a t e d by Paton and L i t t l e t o n : The booking of d e p r e c i a t i o n has no d i r e c t r e l a t i o n to the problem of replacement. I f p e r i o d i c income i s to be p r o p e r l y measured i t " i s necessary to match revenue w i t h a l l c o s t s , i n c l u d i n g d e p r e c i a t i o n , and t h i s r e -quirement remains i n f o r c e even i f there i s novprospect th a t other g e n e r a t i o n s • o f p l a n t w i l l succeed the o r i g i n a l i n s t a l l a t i o n . F u r t h e r , no funds are pr o v i d e d by the process of a c c r u i n g d e p r e c i a t i o n . I t i s through the revenue stream of r e a l i z e d p r o d u c t i o n t h a t the f i n a n c i a l sinews are renewed and i n g e n e r a l i t i s f a i r to say t h a t the s i z e of the stream i s not a f f e c t e d by the amount of assigned cos't.^ I n l i n e w i t h t h i s argument, the net f i x e d a s s e t base seems to be l o g i c a l to use i n the r a t e of r e t u r n on investment measure; i t i s c o n s i s t e n t w i t h income de t e r m i n a t i o n and d e f i n i t i o n . I n some cases, gross f i x e d asset f i g u r e may be b e t t e r to use to a t t a i n a c e r t a i n o b j e c t i v e , f o r example e a r l y r e t i r e m e n t of f a c i l i t i e s . When the gross value i s used i n the investment base, the r e t i r e m e n t o f . a fixed a s s e t takes the o r i g i n a l cost out of the denominator, and so takes out a g r e a t e r f i g u r e than the net asset v a l u e . Management w i t h an eye. to an o p e r a t i n g r a t e of r e t u r n w i l l be encouraged by t h i s to r e t i r e a s s e t s wherever i t f i n d s t h a t improvements i n the r a t e of r e t u r n can be made.,. 1 W.A. Paton and A.C. L i t t l e t o n , An I n t r o d u c t i o n To Corporate Accounting Standards (American"Accounting' A s s o c i a t i o n Monograph No. 3, 1957J, p.59. 2 W i l l i a m Rotch, "Return on Investment as a Measure of Performance" (Unpublished Doctor's D i s s e r t a t i o n , Harvard U n i v e r s i t y , 1958), pp. 121-122. 65 I.W. K e l l e r argues t h a t net f i x e d a s s e t s are e q u a l i z i n g p r o f i t s a r i s i n g out of the o l d e r and newer f a c i l i t i e s : Second, f i x e d a s s e t s are taken at; c o s t , because i t provides a b e t t e r b a s i s of comparison of u n i t s o f the company, some of which may have new a s s e t s and others o l d e r and w e l l - d e p r e c i a t e d a s s e t s . This too i s c o r r e c t i n g " o n l y one phase of a problem. Older p r o d u c t i o n f a c i l i t i e s are g e n e r a l l y l e s s e f f i c i e n t and r e q u i r e more maintenance than new ones. The use of o r i g i n a l c o s t p e n a l i z e s the u n i t u s i n g o l d e r f a c i l i t i e s , i n t h a t i t has h i g h e r cost and thus lower p r o f i t s . I f these are measured a g a i n s t d e p r e c i a t e d v a l u e s , i t s r e t u r n i s more n e a r l y comparable w i t h t h a t of a newer u n i t . * Although g e n e r a l l y t h i s i s . t r u e , i n the case of an asset s t i l l i n use but f u l l y d e p r e c i a t e d , o l d e r f a c i l i t i e s are overcompensated and any income produces an extremely h i g h r a t e , of r e t u r n . This i s due to an i n c o r r e c t estimate of t h e . u s e f u l . l i f e of an a s s e t i n the f i r s t p l a c e . Theoret-i c a l l y , t h i s can be remedied by an adjustment of past income; i n p r a c t i c e , the.adjustment i s made by a charge to d e p r e c i a t i o n allowance and a c r e d i t to income i n the p e r i o d when the d e t e r m i n a t i o n of a c o r r e c t net value of an a s s e t i s made. This v i t i a t e s comparison over time and t h e r e f o r e . s h o u l d be a l l o w e d f o r i n e v a l u a t i o n of managerial performance. R e f l e c t i o n of performance changes i n the r a t e of  r e t u r n on investment. Argument ( 5 ) f o r the use of gross '-assets s t a t e s t h a t : 1 I.Wayne K e l l e r , Management Accounting Por P r o f i t  C o n t r o l (New York: McGraw-Hill, 1 9 5 7 ) , pp. 315-316'. 66 A deduction f o r l i a b i l i t i e s and r e s e r v e s from the amount i n v e s t e d i n o p e r a t i n g p r o p e r t i e s would show a f l u c t u a t i o n i n o p e r a t i n g investment due to growth of r e s e r v e s and changes i n amount of s t o c k h o l d e r c a p i t a l which, i n t u r n , would produce such a d i s t o r t i o n i n the r e t u r n on investment as to render i t meaningless. This argument i s sound i n p r i n c i p l e . Any change i n performance should be r e f l e c t e d i n the change of the r a t e of r e t u r n on investment. I t i m p l i e s , however, a d i m i n u t i o n i n investment base through duduction of accum-ulated, r e s e r v e s and f o r g e t s t h a t these r e s e r v e s , a r e r e p r e s -ented by some a s s e t s i n the b u s i n e s s . Moreover, a c o n t i n -u i n g business w i t h c o n t i n u i n g r e t i r e m e n t s and pruchases, w i l l have, approximately, the same percentage of net to gross f i x e d a s s e t s ; and, u n l e s s i t changes i t s expansion r a t e , the r a t e of r e t u r n on investment w i l l not be d i s t o r t e d . E f f e c t of gross or net a s s e t s on r a t e of r e t u r n on  investment. The choice between the gross and net value of f i x e d a s s e t s a f f e c t s the r a t e of r e t u r n on investment and may l e a d to d i f f e r e n t e v a l u a t i o n s of performance. Table I I I shows the magnitude of the discrepancy which may a r i s e between computations of the r a t e of r e t u r n on the gross and net investment. The d i f f e r e n c e may be not as g r e a t as t h a t shown i n the t a b l e i f annual net income i s p e r m i t t e d to f l u c t u a t e w i t h the net average investment f o r the.year, i . e . , i f i n s t e a d of a constant net annual income of $10,000 per annum a d i m i n i s h i n g income f i g u r e i s assumed r e f l e c t i n g d i m i n i s h i n g p r o d u c t i v i t y of the a s s e t s . The t a b l e , a l s o , ignores new a d d i t i o n s of assets which i s the u s u a l 67 TABLE I I I Comparison of Rate of R e t u r n on G T O S B A s s e t s With Rate of Ret u r n on Net Assets,. Rate of R e t u r n -p fl © •p o ca a © o t> c3 H fl T3 O 0) -H >^ -P eS cd H - H 3 ° s © o ft O © 13 CP -pc3 cn © CD H fl <H H o •p d © fl & W (3 +» © +» © © £ ttf-p © Cd CO r H © © > h > fl O -p © H a) 3 +> fl a © © 2 o +» rH CQ © ail +» fl © s •p -p © © fl o © TTT T2T TTT TTT TTT $100 9000 $25,000 $75,000 $87,500 $10,000 100,000 50,000 50,000 62,500 10,000 100,000 75,000 25,000 37,500 10,000 100 9000 100,000 0 12,500 10,000 100,000 100,000 0 0 35,000 w 10% 10% 10% 10% 35* ~ T 7 7 11,42% 16,00% 26,60% 80.00% I n f i n i t e . (1) O r i g i n a l c o s t o f a s s e t s , (2) D e p r e c i a t i o n based on expected l i f e o f f o u r y e a r s ; s t r a i g h t - l i n e used. A s s e t s a c t u a l l y were used f o r f i v e y e a r s , (3) Column (1) minus Column (2) (4) Net investment a t b e g i n n i n g of y e a r p l u s net investment a t end o f y e a r d i v i d e d by two (e.g. $100.000 + $75,000 » $87,500) (5) Assumed c o n s t a n t income f i g u r e of $10,000, Because no d e p r e c i a t i o n charge was made i n the f i f t h y e a r , the income f i g u r e r i s e s to $35,000 i n t h a t year, (6) Column (5) d i v i d e d by Column ( l ) (7) Column (5) d i v i d e d by Column ( 4 ) . 68 occurence i n p r a c t i c e . Under these c o n d i t i o n s the r a t e of r e t u r n on net a s s e t s may c o n c e i v a b l y be the same as t h a t on g r o s s investment. C o n c l u s i o n s . I f a. c o n s t a n t s t a n d a r d i s imposed from which to measure the r a t e of r e t u r n , the c h o i c e between g r o s s and net a s s e t base s h o u l d p r o b a b l y depend on which method i s more l i k e l y t o produce a c o n s t a n t book r e t u r n on investment each y e a r d u r i n g the l i f e o f the f a c i l i t i e s . N e i t h e r arguments f o r g r o s s a s s e t s nor arguments f o r net a s s e t s are c o n v i n c i n g . Por example, i f age has no i n f l u e n c e on e a r n i n g power, the g r o s s a s s e t s base p r o v i d e s a more r e l i a b l e base f o r i d e n t i f y i n g v a r i a t i o n s i n income due to o t h e r c a u s e s . But, i f e a r n i n g s d e c l i n e w i t h age, o l d e r f a c i l i t i e s a re p e n a l i z e d by r e l a t i n g d e c l i n i n g e a r n i n g power to a c o n s t a n t base. I n t h i s case, net a s s e t s are most l i k e l y to r e f l e c t the c o r r e c t e a r n i n g power. On the assumption t h a t e a r n i n g power does g e n e r a l l y d e c l i n e w i t h age, net a s s e t s are more l i k e l y to r e f l e c t the e a r n i n g power than g r o s s a s s e t s , p r o v i d e d d e p r e c i a t i o n a l l o w -ance corresponds w i t h the stream o f s e r v i c e s r e n d e r e d by the a s s e t s and a. minimum o f overstatement or understatement o f d e p r e c i a t i o n i n any one p e r i o d o c c u r s . The f a c t i s , however, t h a t both g r o s s and net a s s e t s are i m p e r f e c t measures o f . t h e economic v a l u e o f equipment. The net a s s e t base, a l t h o u g h i t does not e s t a b l i s h a " t r u e " r a t e of r e t u r n , i s more c o n s i s t e n t w i t h the d e f i n i t i o n of 69 income than the gross asset hase. I t i s a l s o the amount t h a t appears i n p u b l i s h e d statements. . I . Wayne K e l l e r suggests t h a t : The prime danger i n d e p a r t i n g from the p u b l i s h e d f i n a n c i a l statements i s tha t management time, which should be devoted to h o l d i n g and improving the r a t i o s , w i l l be d i v e r t e d to a t t a c k s upon the v a l i d i t y of the amount of c a p i t a l i n determining the r a t i o s . * The m a j o r i t y of informed opinion.seems to favour the use of net as s e t s i n the investment base. H.A.A. Sesearch Report 35 i s s u e d i n 1959 s t a t e s t h a t : ... f i e l d i n t e r v i e w s i n t h i s study show t h a t 18 out of 28 companies u s i n g t o t a l a s s e t s as the i n v e s t -ment base.do deduct, accumulated d e p r e c i a t i o n . g I n a d d i t i o n , f o r a company as a whole,-the aggregate net a s s e t s f i g u r e tends to be s t a b i l i z e d by reinvestment of c a p i t a l recovered or even i n c r e a s e d by a d d i t i o n a l investments. R e t e n t i o n o f-recovered c a p i t a l i n the company tends to o f f -s e t the r e d u c t i o n of a s s e t s by d e p r e c i a t i o n and s t a b i l i z e the r a t e of r e t u r n on investment. Where the proper guidance of d i v i s i o n managers i s the main o b j e c t i v e , gross a s s e t s may be used to encourage e a r l y r e t i r e m e n t s and replacements and net as s e t s may be used to discourage such r e t i r e m e n t s . 1 I . Wayne K e l l e r , "The Return on C a p i t a l Concept," N.A.A. B u l l e t i n , March, 1958, p. 17. 2 Return on C a p i t a l as a. Guide to Managerial D e c i s i o n s (N.A.A. Research Report 35, 1959), p . l l . 70 CHAPTER V I I USES OP THE RATE OP RETURN ON INVESTMENT The main uses of the r a t e of r e t u r n on investment t h a t were conside r e d i n t h i s paper concern e v a l u a t i o n of both company and d i v i s i o n a l performance. The two unanswered questions posed at the beginning- of t h i s paper a r e : 1. Does the use. of the r a t e of r e t u r n on i n v e s t -ment l e a d to any b e t t e r performance ? 2. Does the r a t e of r e t u r n on investment i d e n t i f y good and bad performance and p o i n t to where perform-ance can be improved ? I f the r a t e of r e t u r n on investment does not l e a d or might not l e a d to any b e t t e r performance, then a v e r y good reason f o r i t s adoption i s m i s s i n g . A l s o , i f i t does not help i n i d e n t i f y i n g good and bad performance, i t cannot.Lbe used as a guide to a c t i o n nor can i t be used i n e v a l u a t i n g managerial performance. Even i f i t i s concluded that the r a t e of r e t u r n on investment i s a good measure of performance, e v a l u a t i o n of r e s u l t s must be s t i l l undertaken. This i m p l i e s d e t e r m i n a t i o n , conscious or unconscious, of standards i n d i c a t i n g what i s a s a t i s f a c t o r y r a t e of r e t u r n . Because of u n c o n t r o l l a b l e f a c t o r s a f f e c t i n g performance, standards cannot be made i n f l e x i b l e ; the e v a l u a t i o n should take a l l r e l e v a n t f a c t o r s i n t o account. 71 Improvement i n performance through, use o f r a t e  of r e t u r n on investment. The f o l l o w i n g are some of the-t h i n g s t h a t "both d i v i s i o n and top management might do i n o r d e r to improve performance. I t does not mean t h a t t h e s e are the t h i n g s t h a t management w i l l do; p r o p e r i n c e n t i v e s and m o t i v a t i o n must be a p p l i e d to induce managers to use the r a t e of r e t u r n on investment i n s e e k i n g improvements i n t h e i r performance. I t i s r e a s o n a b l e to expect a d i f f e r e n t a c t i o n w i t h r e s p e c t t o f i x e d a s s e t s . I n replacements o f f i x e d a s s e t s and, g e n e r a l l y , i n c a p i t a l b u dgeting, managers have an o p p o r t u n i t y t o base t h e i r d e c i s i o n s on the r a t e of r e t u r n c a l c u l a t i o n s . S e l e c t i o n o f investments w i t h h i g h income c o n t r i b u t i o n s w i l l undoubtedly l e a d to a b e t t e r performance. The r a t e of r e t u r n on investment can a l s o be a u s e -f u l guide i n changing i n v e n t o r y l e v e l from one l e v e l t o another, f o r example, from 1 5 to 2 0 days s u p p l i e s . Once, however, a c e r t a i n l e v e l has been d e c i d e d on, i t i s no l o n g e r an investment d e c i s i o n but r a t h e r c a r r y i n g out o f p r e v i o u s d e c i s i o n . S i m i l a r l y w i t h accounts r e c e i v a b l e . The change o f terms, when t h i s i s p o s s i b l e , w i l l be i n f l u e n c e d by the r a t e o f r e t u r n on investment. F r e d e r i c k J . Muth i n d i c a t e d the way the r a t e o f r e t u r n can be used to improve p r o f i t a b i l i t y by c h o o s i n g the r i g h t p r o d u c t s : 72 Because of the many products i n the Armstrong l i n e , i t was r e c o g n i z e d t h a t the approaches to improvement i n r e t u r n would n e c e s s a r i l y d i f f e r . As a guide f o r management p l a n n i n g , The P r e s i d e n t ' s O f f i c e suggested t h a t a l l products he c l a s s i f i e d under t h r e e c a t e g o r i e s : (1:) those earning a r e l a t i v e l y h i g h r e t u r n , (2) those e a r n i n g a modest r e t u r n , and (3) those earning an u n s a t i s f a c t o r y r e t u r n or showing a l o s s . O b viously, the o b j e c t i v e i n d e a l i n g w i t h commodities i n Category 1 i s to p l a y to s t r e n g t h , to i n c r e a s e the share of the company's business t h a t i s done i n these p r o f i t a b l e e n t e r p r i s e s . This i s implemented by s t r i v i n g to i n c r e a s e s a l e s volume through s p e c i a l s a l e s e f f o r t , a d v e r t i s i n g and promotion, and investment f o r i n c r e a s e d p r o d u c t i v e c a p a c i t y where i t can be s o l d . These com-mod i t i e s r e c e i v e i n t e n s i v e r e s e a r c h to develop new uses and markets. They a l s o are s t u d i e d to analyze c h a r -a c t e r i s t i c s which can p o s s i b l y be matched i n other commodities to promote.the development and o f f e r i n g of companion products or other items s e r v i n g the same or s i m i l a r markets. Items i n Category 2 are s t u d i e d to seek ways by > which they might be improved i n t o the more p r o f i t a b l e Category 1 through some combination of the f o l l o w i n g approaches. 1 . Cost r e d u c t i o n 2. Sales pressure f o r i n c r e a s e d volume. 3. , Higher s a l e s p r i c e s . 4. Reduction i n c a p i t a l employed through reduced i n v e n t o r y of f i n i s h e d goods, goods i n process and raw m a t e r i a l s , s i m p l i f i c a t i o n of product l i n e s , obsolescence of unnecessary equipment, e t c . 5. E l i m i n a t i o n of the l e a s t p r o f i t a b l e items, e s p e c i a l l y l o s s items, i f any, w i t h i n the commodity or product l i n e . Any commodity or product group i n Category 3 i s a drag on the company, s i n c e i t r e p r e s e n t s c a p i t a l and 73 e f f o r t t h a t do not provide an adequate r e t u r n to i n s u r e our f u t u r e s t r e n g t h , s t a b i l i t y , and growth; t h e r e f o r e , a l l products i n Catagory 3 are kept under c l o s e s c r u t -i n y i n an attempt to achieve, as promptly as p o s s i b l e , e i t h e r a s a t i s f a c t o r y r a t e of p r o f i t or e l i m i n a t i o n of the commodity.-P a u l W. Lyon has d e s c r i b e d i n h i s a r t i c l e "Operat-i n g Return on Operating Investment" how h i s company, West V i r g i n i a Pulp-and Paper Company, improved performance through a p p l i c a t i o n of the r a t e of r e t u r n on investment: A f t e r l o c a l i z i n g our problems i n performance among o p e r a t i n g u n i t s , we began to use our a n a l y t i c a l t o o l i n s i d e the i n d i v i d u a l o p e r a t i n g u n i t s . S p e c i f i c a l l y , we s t a r t e d to develop co s t i n f o r m a t i o n which would show what r a t e of r e t u r n on. investment any g i v e n grade of paper would y i e l d on any g i v e n machine i n each of our m i l l s . Again, as when comparing- one " m i l l a g a i n s t another, we found t h a t there were s i z a b l e ' d i f f e r e n c e s i n the p r o f i t a b i l i t y of grades produced. I n c e r t a i n m i l l s which had some r e l a t i v e l y m arginal grades, we found! orders of magnitude of s i x or seven' to one i n terms of d i f f e r e n c e s i n p r o f i t a b i l i t y as expressed by r a t e of r e t u r n on investment. I n many cases, these d i f f e r e n c e s i n p r o f i t a b i l i t y would not have been uncovered had we used o n l y a m a r g i n - o f - p r o f i t - w i t h - r e s p e c t - t o - s a l e s type of a n a l y s i s . Por example, we have some grades of paper which show b e t t e r margins of p r o f i t on s a l e s than other grades which can be produced on.the same equipment. Yet, because of d i f f e r e n c e s i n the amounts of paper which 1 F r e d e r i c k J . Muth, "Return on I n v e s t m e n t — Tool of Modern Management," Improved Tools of F i n a n c i a l  Management (New York: American Management A s s o c i a t i o n F i n a n c i a l Management S e r i e s No: 111, 1956), pp. 10-11. 74 can "be produced per hour, the r a t e of r e t u r n on i n v e s t -ment y i e l d e d by the grade w i t h lower margin of p r o f i t can be s u b s t a n t i a l l y g r e a t e r . ^ With a proper a l l o c a t i o n of investment and c o s t s , the same a n a l y s i s can be c a r r i e d . t h r o u g h w i t h r e s p e c t to p l a n t and sub-units of a company. I t does not mean, however, t h a t the use of the r a t e of r e t u r n on investment measure i s an insurance a g a i n s t poor d e c i s i o n s ; what i s advanced i s th a t through c e r t a i n kinds of a c t i o n , s i m i l a r to those d e s c r i b e d above, an improvement i n the r a t e of r e t u r n , i f any, can be a t t a i n e d . Another important v a r i a b l e i s the p s y c h o l o g i c a l e f f e c t of the r a t e of r e t u r n on investment on managers. I t may symbolize t o them independence and thus r e s u l t I n improved performance. Powered w i t h the r i g h t i n c e n t i v e , . t h e r a t e of r e t u r n on investment may become a potent f o r c e . c o m p e l l i n g managers to l o o k f o r improvements i n performance. There i s not, however, s t a t i s t i c a l evidence t h a t t h i s i s the case; such p o s s i b i l i t y should not be r u l e d out. W i l l i a m Rotch t h i n k s , however, t h a t the f e e l i n g of independence i s s h o r t -l i v e d and tends to be o v e r r a t e d by top management who assume th a t the r a t e of r e t u r n on investment g i v e s subordinates more enthusiasm f o r t h e i r jobs than i s the case i n f a c t . 2 _ P a u l W. Lyon, "Operation Return on Operating I n v e s t -ment ," Improved Tools o f , F i n a n c i a l Management (New York: American Management A s s o c i a t i o n F i n a n c i a l Management S e r i e s No: 111, 1956), p..20. 2 ' W i l l i a m Rotch, "Return on Investment as a Measure of Performance." (Unpublished Doctor's D i s s e r t a t i o n , Harvard U n i v e r s i t y , 1958), pp. 55-56. 75 The c o n c l u s i o n i s t h a t the use of r a t e o f r e t u r n on investment may i d e n t i f y good and bad performance and may l e a d to a b e t t e r performance. Problems i n e v a l u a t i n g the r a t e o f r e t u r n on investment. A p p r a i s a l o f performance i n terms of the r a t e o f r e t u r n i m p l i e s c e r t a i n optimum st a n d a r d s o f performance a g a i n s t which a c t u a l performance i s measured. I . Wayne K e l l e r says t h a t no f o r m u l a has been developed to do t h i s and suggests c e r t a i n ways of s e t t i n g s t a n d a r d s : I f p r o f i t s are to be measured and c o n t r o l l e d , t h e r e s h o u l d be some method of determining- the optimum and the maximum r e t u r n on c a p i t a l employed. U n f o r t u n a t e l y , no f o r m u l a has been developed which v / i l l do t h i s , judgment, based on comparisons w i t h o t h e r companies and the e x p e r i e n c e o f the company, i s the o n l y method of s e l e c t i n g optimum and maximum r e t u r n - o n - c a p i t a l -employed o b j e c t i v e s . The major f a c t o r s t o be c o n s i d e r e d a r e : 1 . The b e s t and the average r e t u r n s of a l l companies. 2. The b e s t and average r e t u r n s o f s i m i l a r i n d u s t r i e s . 3. The company p o s i t i o n i n the i n d u s t r y . 4. The c o m p e t i t i v e v a l u e o f p a t e n t s o r s e c r e t p r o c e s s e s o f the company. 5. P o s s i b i l i t y o f new b u s i n e s s e s e n t e r i n g the f i e l d and becoming s i g n i f i c a n t c o m p e t i t o r s M W i l l i a m J . V a t t e r i n d i s c u s s i n g the problem o f d e t e r m i n a t i o n o f a normal r e t u r n f o r the r i s k o f a g i v e n e n t e r p r i z e s t a t e s t h a t t h i s q u e s t i o n i s : 1 I . Wayne K e l l e r , Management A c c o u n t i n g f o r P r o f i t  G o n t r o l (NewYork: McGraw-Hill7 1957), p.317. 7 6 ... answerable o n l y i n terms of averages o r comparisons w i t h o t h e r f i r m s , t h e r e i s no way to e s t a b l i s h o b j e c t -i v e l y and p o s i t i v e l y the r a t e o f r e t u r n which j u s t c overs normal r i s k s of an i n d u s t r y . Thus our r a t e of r e t u r n measure must always be t a r e l a t i v e measurement, w i t h no a b s o l u t e s c a l e o f r e f e r e n c e . T h i s does not i n v a l i d a t e the r a t e of r e t u r n , but i t c e r t a i n l y c a l l s f o r comparisons and a n a l y s i s b e f o r e c o n c l u s i o n s are drawn.* In the s e l e c t i o n of standards o f evaluating- the r a t e o f r e t u r n as a measure o f performance a l l r e l e v a n t f a c t o r s must be c o n s i d e r e d . I t i s suggested t h a t i n a d d i t i o n to comparisons of a company w i t h o t h e r f i r m s , a h i s t o r i c a l r e v i e w of company performance over time might be u s e f u l i n a p p r a i s i n g management, e.g., comparison o f t h i s y e a r ' s performance w i t h t h a t of the l a s t y e a r . D i v i s i o n s can.be compared with, o t h e r d i v i s i o n s , o r w i t h the company as a whole, o r w i t h the d i v i s i o n a l performance o f . t h i s y e a r w i t h p r e v i o u s y e a r s . These com-p a r i s o n s , however, r e q u i r e i n t e r p r e t a t i o n and-judgment.' Comparisons w i t h o t h e r d i v i s i o n s o r w i t h the company as a whole must take i n t o account d i f f e r i n g r i s k s i n . t h e b u s i n e s s and d i f f e r e n t c o s t s i n d i v i s i o n s , such as product d e v e l o p -ment r e s e a r c h c a r r i e d by one and not by the o t h e r , or the c o s t s o f p u t t i n g new f a c i l i t i e s i n t o o p e r a t i o n . T h e o r e t i c a l l y , comparisons w i t h o t h e r companies are easy. I n p r a c t i c e , t h i s i s hampered.by d i f f e r e n c e s i n a c c o u n t i n g systems o r , i n some cas e s , l a c k of p u b l i s h e d _ W i l l i a m J . V a t t e r "Does the Rate of R e t u r n Measure Busi n e s s E f f i c i e n c y f " N.A.A. B u l l e t i n , January, 1 9 5 9 , p . 3 4 . 77 f i g u r e s . A comparison of a d i v i s i o n of one company w i t h a d i v i s i o n of another company i s not f e a s i b l e because of l a c k of r a t e of r e t u r n f i g u r e s . Comparisons of a company or a d i v i s i o n w i t h the i n d u s t r y are easy but o n l y u s e f u l to get rough l e v e l s of r e t u r n . Even w i t h i n an i n d u s t r y , companies d i f f e r s i g n -i f i c a n t l y i n t h e i r r a t e s of r e t u r n . I . Wayne K e l l e r says t h a t , "Companies w i t h h i g h , average, and low r e t u r n s are found i n e v e r y . i n d u s t r y . The r e t u r n achieved i s the r e s u l t of management, and no company should f e e l t h a t i t s r e t u r n i s s a t i s f a c t o r y u n t i l i t i s i n the upper q u a r t i l e of a l l companies.".. L a t e r , K e l l e r goes on to say: Because of these v a r i o u s i n f l u e n c e s on r e t u r n on c a p i t a l employed, a company w i t h a broad product l i n e should not expect to r e a l i z e the same r e t u r n on a l l products. Separate o b j e c t i v e s need to be e s t a b l i s h e d f o r each l i n e and f o r the t o t a l company. The maximum average r e t u r n over the p e r i o d of a business c y c l e should not be so high t h a t i t s u b s i d i z e s i n e f f i c i e n t competitors or i n v i t e s new competition.-As a r u l e of thumb, i t would appear th a t a r e t u r n on c a p i t a l of 20% i n a product l i n e i s almost the maximum th a t should be expected to be h e l d over a p e r i o d of ye a r s , even w i t h patent p r o t e c t i o n . For t o t a l company r e t u r n , the h i s t o r i c a l p a t t e r n i s a range of from 10% to 15% f o r companies which are g e n e r a l l y considered to be s u c c e s s f u l growth companies.2 " \ ' I . Wayne K e l l e r , Management Accounting f o r P r o f i t  C o n t r o l (New York: McGraw-Hill, 1957J, p. 317. 2 I b i d . , pp. 318-319. 78 I n view of the above comments, l a c k o f p r e c i s e s t a n d a r d s seems to be not a s u f f i c i e n t r e a s o n to abandon e v a l u a t i o n i n terms of the r a t e o f r e t u r n . Comparisons w i t h o t h e r companies i n the same i n d u s t r y o r w i t h the b e s t man-aged companies may h e l p to s e t a t t a i n a b l e s tandards f o r the company. Comparisons o f a d i v i s i o n w i t h o t h e r s i m i l a r d i v -i s i o n s i n the same company, i n case of d i v i s i o n s d e c e n t r a l -i z e d g e o g r a p h i c a l l y , o r w i t h the r a t e o f r e t u r n s e t f o r the company as a whole, o r comparisons o f a d i v i s i o n a l p e r -formance over time, s h o u l d guide top management i n e s t a b l i s h -i n g d i v i s i o n a l p r o f i t o b j e c t i v e s . As suggested by K e l l e r i n the a b o v e . q u o t a t i o n , p r o f i t o b j e c t i v e s f o r d i f f e r e n t p r o d u c t l i n e s o r d i v i s i o n s s h o u l d take i n t o account s p e c i a l c h a r -a c t e r i s t i c s s u r r o u n d i n g them. The most important problem i n the use of r a t e o f r e t u r n on investment i n e v a l u a t i o n o f performance l i e s i n t h a t a l l s i t u a t i o n s have s p e c i a l c h a r a c t e r i s t i c s . R e f l e c t e d i n the r a t e o f r e t u r n f i g u r e a re s p e c i a l c h a r a c t e r i s t i c s o f a d i v i s i o n , a company, or i n d u s t r y i n q u e s t i o n . I m p o s s i b i l i t y o f d e t e r m i n i n g p r e c i s e s tandards of p e r f o r m -ance i n a r e l i a b l e manner, f o r c e s top management to I n t e r p r e t comparisons i n the l i g h t o f i t s knowledge o f b u s i n e s s and s p e c i f i c c o n d i t i o n s s u r r o u n d i n g o p e r a t i o n s and.come to a c o n c l u s i o n about what a good r a t e o f r e t u r n i s . Performance a p p r a i s a l o f a company. A p p r a i s a l o f a company performance and, a t the same time, of top manage-ment's e f f e c t i v e n e s s i n u t i l i z i n g the r e s o u r c e s under i t s 79 c o n t r o l can be made i n three s t a g e s : 1. Present company performance i n r e l a t i o n t o past performance. 2. Present company performance i n r e l a t i o n t o performance of com p e t i t o r s . 3. Present company performance i n r e l a t i o n to companies n a t i o n a l l y r e c o g n i z e d to be well-managed businesses.^ Por the purposes of i l l u s t r a t i o n , a h y p o t h e t i c a l company "X" i s assumed. H i s t o r i c a l comparison of performance. The r e t u r n on investment of "X" Company from 1953 to 1958 has been as shown i n Table IV. TABLE IV Return on Investment of "X" Company from  1953 to 1958 Year Per cent Return on Investment 1953 11 1954 12 1955 13 1956 9 1957 7 1958 5 The t a b l e shows a d i m i n i s h i n g r a t e of r e t u r n to a 1 F r e d e r i c k J . Muth, "Return on I n v e s t m e n t — T o o l of Modern Management," Improved.Tools of F i n a n c i a l Management (New York: American Management A s s o c i a t i o n F i n a c i a l Manage-ment S e r i e s No: 111, 1956), pp. 5-8. 80 low f i g u r e o f f i v e p e r cent i n 1958. I t i s , t h e r e f o r e , n e c e s s a r y to i n v e s t i g a t e f u r t h e r and determine whether "X" Company.suffered from g e n e r a l economic c o n d i t i o n s or whether poor r e s u l t s are an i n d i c a t i o n o f l e s s e n i n g of m a n a g e r i a l e f f e c t i v e n e s s . T h i s l e a d s i n t o the next stage o f com-p a r i s o n — the comparison of "X" Company's performance w i t h c o m p e t i t i o n . Comparison w i t h c o m p e t i t i o n . T a b l e V makes the comparison w i t h c o m p e t i t i o n ; I t shows that, companies i n the same i n d u s t r y have not s u f f e r e d a d e c l i n e I n t h e i r e a r n i n g s and, t h e r e f o r e , the e x p l a n a t i o n f o r d i m i n i t i o n o f "X" Company's r a t e of r e t u r n must be sought i n i t s o p e r a t i o n s . TABLE V Comparison w i t h C o m p e t i t i o n Company P e r Gent R e t u r n on Investment A 14 B 12 C 11 D 10 E 9 P 8 G 7 "X" Company 6 1 .5 The r e s u l t s o f each company are broken down i n Tabl e VI i n terms o f the r a t e o f r e t u r n on investment f o r m u l a : Net Income x S a l e s = R e t u r n on Investment S a l e s Investment 81 TABLE VI A n a l y s i s of the r a t e of r e t u r n of chosen companies i n the same i n d u s t r i e s p.er cent P/ercentage of Return on income on Company Investment Sales Turnover A 14 8 1.7 B 12 6 2.0 C . 11 11 1.0 D 10 5 2.0 E 9 3 3.0 F 8 4 2.0 G 8 5 1.6 "X" Company '6 4 1.5 I 5 3 1.6 Table VI r e v e a l s why income on s a l e s i s not a good measure of performance. Company C has the hig h e s t income on s a l e s , eleven per cent, yet i t . s t a n d s t h i r d i n the r a t e of r e t u r n on investment r a n k i n g . By a n a l y s i n g i n -come on s a l e s and turnover f i g u r e s f o r c o m p e t i t i v e companies, i t can be found t h a t , although "X" Company's income on s a l e s i s . t h e same.as that of company P and even b e t t e r than th a t of company E, i t s turnover i s much lower. By improving i t s t u r nover, "X" Company w i l l be able to r a i s e i t s r a t e of r e t u r n on investment. More i n t e n s i v e s a l e s e f f o r t i s i n -d i c a t e d ; i n c r e a s e i n s a l e s may l e a d to lower cos t s through b e t t e r u t i l i z a t i o n of ex i s t i n g - f a c i l i t i e s . D e t a i l e d a n a l y s i s , of operations i n terms of r a t e of r e t u r n may h e l p to uncover ways of improving performance. Comparison w i t h weII-managed companies. F i n a l l y , "X" Company can be compared w i t h the well-managed companies, 82 not n e c e s s a r i l y i n the same i n d u s t r y . Por the purposes of i l l u s t r a t i o n , s i x f i r m s were s e l e c t e d from the 500 l a r g e s t U.S... I n d u s t r i a l . C orporations appearing i n the Fortune D i r e c t o r y i n 1959.^ TABLE VII. Comparison w i t h well-managered companies. Company Per Cent Rate of Return on Investment Du Pont (E.I.) de Nemours 12.16 Eastman Kodak 12.04 Standard O i l of C a l i f o r n i a 10.51 General E l e c t r i c 10.00 General M 0 t o r s 8.71 I n t e r n a t i o n a l Paper 8.07 "X" Company 6.00 Competitive companies shown i n Table V, companies A,B,C,D,E, and F, show r a t e s of r e t u r n from e i g h t per cent to f o u r t e e n per cent; t h i s compares f a v o u r a b l y w i t h the r a t e s of r e t u r n of the best managed companies. I t can be concluded th a t "X?l Company i s engaged i n an i n d u s t r y which can produce a r e t u r n on investment e q u i v a l e n t to those produced by outs t a n d i n g management of companies i n Table V I I . With these b a s i c data e s t a b l i s h e d , "X" Company i s i n a p o s i t i o n of e v a l u a t i n g i t s performance'trend a g a i n s t 1 The Fortune D i r e c t o r y , The 500 l a r g e s t U.S.  I n d u s t r i a l Corporations' (Fortune, J u l y , 1959)» p. 126. 83 p a s t e x p e r i e n c e , c o m p e t i t i o n , and the r e c o r d of the s e l e c t e d group of well-managed companies. T h i s i n i t i a l d i a g n o s i s must he f o l l o w e d through by examining d i v i s i o n a l performance, p l a n t performance, product performance, and so on, l o o k i n g f o r areas of s t r e n g t h s and weaknesses. A p p r a i s a l of d i v i s i o n a l performance. S i n c e i t i s not p o s s i b l e t o e s t a b l i s h the " r i g h t " r a t e of r e t u r n and because i t i s u s u a l l y not p o s s i b l e to o b t a i n r e l e v a n t data on performance of s i m i l a r d i v i s i o n s i n o t h e r companies, comparisons of c u r r e n t d i v i s i o n a l performance must be l i m i t e d to a h i s t o r i c a l r e view o f p a s t performance, i . e . , performance o f " o t h e r d i v i s i o n s w i t h i n the company, and to- the performance o f t h e company as a whole. The a n a l y s i s suggested i n the p r e v i o u s paragraph can be a l s o undertaken i n a p p r a i s i n g d i v i s i o n a l performance. I t must be^oiwever, born i n mind t h a t c e r t a i n c o n d i t i o n s , enumerated e a r l i e r i n Chapter IV, must be met i f the r a t e of r e t u r n on investment i s to r e f l e c t the.performance of a d i v i s i o n a l manager. I n describing- Armstrong Cork Company ex p e r i e n c e , F r e d e r i c k J . Muth s t r e s s e s the importance of d i v i s i o n a l manager's independence: The company i s d e c e n t r a l i z e d to the d i v i s i o n a l l e v e l , from which p o i n t i t i s h i g h l y c e n t r a l i z e d , r e c o g n i z i n g t h a t r e s p o n s i b i l i t y f o r r e t u r n on 84 d i v i s i o n a l investment i s d e l e g a t e d to the d i v i s i o n a l manager. The d i v i s i o n a l manager d i r e c t s the p r o d u c t i o n and d i s t r i b u t i o n of the p r o d u c t s w i t h i n h i s d i v i s i o n and does not expect i n t e r f e r e n c e from top management beyond the p o i n t of common c o u n s e l l i n g ' i n d e c i s i o n s as t o " b o t h m a n u f a c t u r i n g and.sales matters u n l e s s they c o n f l i c t w i t h o v e r - a l l company p l a n n i n g . T h i s proper d e l e g a t i o n of p r o f i t r e s p o n s i b i l i t y i s o f t e n d i f f i c u l t f o r top management groups to a c h i e v e , but i t i s a 'must' under the r e t u r n - o n - i n v e s t m e n t t h e o r y . 1 I f t h i s i s not done, then the top management i s e v a l u a t i n g i t s e l f . I n a p p r a i s i n g d i v i s i o n a l performance, ; allowance must be made f o r u n c o n t r o l l a b l e f a c t o r s ; as ment-io n e d b e f o r e , these are o f t e n i n e x t r i c a b l y i n t e r t w i n e d w i t h f a c t o r s over which the d i v i s i o n manager has c o n t r o l and t h e r e b y obscure e v a l u a t i o n . Of. n e c e s s i t y , the d i v i s i o n a l s t a n d a r d must be a r e l a t i v e measure. P a s t e x p e r i e n c e and company e x p e c t a t i o n s s h o u l d s e r v e as guides i n s e t t i n g s tandards f o r d i v i s i o n managers. To be e f f e c t i v e , s tandards must be known and r e l a t e d to some k i n d of an i n c e n t i v e system. 1 " F r e d e r i c k J . Muth, "Return on Investment — T o o l of Modern Management," Improved T o o l s of F i n a n c i a l Management (New York: American Management A s s o c i a t i o n F i n a n c i a l Management. S e r i e s No. I l l , 1956), pp. 8-9. 85 CHAPTER V I I I SPECIAL:,PROBLEMS OP THE RATE OP RETURN ON INVESTMENT I n the f o l l o w i n g paragraphs some of the problems not covered i n p r e v i o u s c h a p t e r s are touched upon and the l i m i t a t i o n s of the r a t e o f r e t u r n summarized. The problems, c o n c e r n the use of r a t e of r e t u r n on investment i n a p p r a i s -i n g . d i v i s i o n a l performance, namely, e s t a b l i s h m e n t o f t r a n s f e r p r i c e s , l e a s i n g o f f a c i l i t i e s , and investment d e c i s i o n s made at d i v i s i o n l e v e l . I ESTABLISHMENT OP TRANSFER PRICES G e n e r a l background. When d i v i s i o n s , a r e e v a l u a t e d i n terms of the r e t u r n on investment and t r a n s f e r p r o d u c t s from one d i v i s i o n to another, i t i s important t h a t v a l u e added be r e f l e c t e d i n t r a n s f e r p r i c e s , o t h e r w i s e d i s t o r t i o n o f d i v i s i o n a l performance w i l l r e s u l t . There are a number of systems which can be used t o e s t a b l i s h the p r i c e . The p r i c e may be 'negotiated by the d i v i s i o n managers, i t may be based on market, or on c o s t p l u s a percentage r e t u r n on •investment, o r a. c o m b i n a t i o n of a l l these methods. Whatever method i s used, the d i v i s i o n a l manager s h o u l d not be com-p e l l e d t o use any method- which w i l l d e t r i m e n t a l l y a f f e c t h i s r a t e o f r e t u r n on investment. From the p o i n t o f maximizing company's p r o f i t , the o n l y t r a n s f e r s t h a t s h o u l d be made are those'which i n c r e a s e the p r o f i t o f the company. The d i v i s i o n manager.should not 8 6 be a b l e t o . i n c r e a s e h i s p r o f i t a t the expense o f o v e r a l l p r o f i t a b i l i t y . One d i v i s i o n s h o u l d not be f a v o u r e d a t the expense of another. Intra-company p r i c e d i s c r i m i n a t i o n i s not good b u s i n e s s ; such measures are bound-to be a r b i t r a r y and a u t h o r i t a r i a n and p r o v i d e a poor b a s i s f o r a p p r a i s i n g d i v i s i o n a l performance, obscure p r o f i t s , and d i v e r t e f f o r t s i n t o uneconomic c h a n n e l s . The d i v i s i o n a l o b j e c t i v e s s h o u l d be i d e n t i c a l w i t h the i n t e r e s t s of the company as a whole; a t the same time, the d i v i s i o n manager's autonomy must be p r e s e r v e d , otherwise the e v a l u a t i o n o f " h i s performance i n terms-of the r a t e of r e t u r n on investment l o s e s s i g n i f i c a n c e . N e g o t i a t e d t r a n s f e r p r i c e s . J o e l Dean f e e l s t h a t the b e s t way to a c h i e v e the i d e n t i t y of purpose and o b j e c t i v e s between d i v i s i o n s and the company i s to adhere to the f o l l o w -i n g p r i n c i p l e s : -( 1 ) P r i c e s of a l l t r a n s f e r s i n and out of a p r o f i t c e n t e r s h o u l d be determined by n e g o t i a t i o n between buyers and s e l l e r s . (2) N e g o t i a t o r s s h o u l d have ac c e s s to f u l l . d a t a on a l t e r n a t i v e sources and markets and to p u b l i c and p r i v a t e i n f o r m a t i o n about market p r i c e s . (3) Buyers and s e l l e r s s h o u l d be c o m p l e t e l y f r e e t o • d e a l o u t s i d e the company.* Under the s e c o n d i t i o n s top management can d e l e g a t e a u t h o r i t y to d i v i s i o n managers without undue f e a r because the d i v i s i o n managers' p r o f i t g o a l s are the same as those of 1 J o e l Dean, " D e c e n t r a l i z a t i o n and Intra-company P r i c i n g , " H a r v a rd B u s i n e s s Review, 'July-August, 1 9 5 5 , p. 6 8 . 87 the top management. The b u y i n g d i v i s i o n w i l l not buy a t h i g h e r p r i c e s *than the market, and the s e l l i n g d i v i s i o n w i l l not s e l l f o r l e s s than the market. I n . s e e k i n g to maximize i t s own p r o f i t s , the d i v i s i o n w i l l a l s o maximize the p r o f i t s o f the e n t i r e company. Alt h o u g h t h e o r e t i c a l l y sound, Dean's p r o p o s i t i o n may be, i n p r a c t i c e , d i f f i c u l t to implement and a c c e p t . The a c c e s s to p u b l i c and p r i v a t e i n f o r m a t i o n about- market p r i c e s i s not always a v a i l a b l e . But even i f market p r i c e s c o u l d be o b t a i n e d , they would not be the same, as the p r i c e s emerging i n the case where l a r g e t r a n s f e r s , i n s t e a d of b e i n g t r a d e d i n s i d e the company., were thrown on .the market. T h i s draw-back, however, i s remedied by n e g o t i a t i o n s . But here a g a i n i t may be the* s k i l l e d b a r g a i n i n g a b i l i t y r a t h e r t han economic f e a s i b i l i t y of a t r a n s a c t i o n t h a t w i l l p r e v a i l . U n f e t t e r e d s e l f i s h n e s s o f the d i v i s i o n managers may, a t times, be s h o r t - s i g h t e d by f o r e g o i n g l o n g - r u n advantages and c o n c e n t r a t i n g on s h o r t - t e r m r e s u l t s . Some d i v i s i o n s may prove to be u n p r o f i t a b l e a t the moment, but promise r i c h rewards i n the f u t u r e . E l i m i n a t i o n of such d i v i s i o n s may r e s u l t i n i n j u r i n g the p r o s p e c t s of s u r v i v a l f o r the company. T h e r e f o r e , some i n t e r f e r e n c e and d i r e c t i o n from the top management may be a d v i s a b l e . N e v e r t h e l e s s , neg-o t i a t i o n s over p r i c e s have the advantage of a v o i d i n g a r b i t r a r i n e s s and c r e a t i n g agreement among e x e c u t i v e s . T r a n s f e r s a t c o s t . T r a n s f e r s a t c o s t are not conducive t o agreement; f r i c t i o n i s l i k e l y t o develop between 88 d i v i s i o n a l managers u s i n g c o s t s in.intra-company t r a n s f e r p r i c i n g . The method sounds si m p l e , hut i t i s e xtremely d i f f i c u l t to implement w i t h o u t some a u t h o r i t a r i a n d i r e c t i o n from above. The word " c o s t " , though simple, stands f o r a s e t of complex ideas.' 'For example,.in a d i v i s i o n p r o d u c i n g s e v e r a l p r o d u c t s a t d i f f e r e n t c o s t s , the q u e s t i o n i s which c o s t s are the most a p p r o p r i a t e to use. Should the t r a n s f e r s be a t c o s t on the low-cost l i n e , a t c o s t on the h i g h - c o s t l i n e , at an average c o s t o f a l l p r o d u c t s or a c o s t - p l u s f i g u r e ? Should i t be a t s t a n d a r d c o s t , o r an a c t u a l c o s t ? Should overhead be i n c l u d e d or not ?. T h i s paper w i l l not t r y to answer a l l these q u e s t i o n s . No one cost- method meets the requirements o f the r a t e o f r e t u r n on investment measure. There are v a r i o u s degrees o f a r b i t r a r i n e s s i n a l l c o s t methods... In a d d i t i o n , when many. d i v i s i o n s handle p r o d u c t s i n s u c c e s s i o n , t r a n s f e r s a t c o s t do not p r o v i d e any p r o f i t to the i n s i d e s e l l i n g d i v i s i o n — a l l the p r o f i t i s t aken up by the. d i v i s i o n s e l l i n g to the o u t s i d e market. A l s o o p e r a t -i n g management may o v e r l o o k p r o f i t a b l e changes i n methods o r p r o d u c t f l o w s because the i n e f f i c i e n c i e s of one d i v i s i o n are c o v e r e d up by the low c o s t - o f more e f f i c i e n t d i v i s i o n s t h a t worked on the p r o d u c t i n e a r l i e r s t a g e s . T r a n s f e r s a t c o s t p l u s a - r e t u r n on investment. I n the c o s t p l u s a r e t u r n on investment t r a n s f e r p r i c i n g a l l the d i f f i c u l t i e s o f t r a n s f e r s a t c o s t are a l s o p r e s e n t , w i t h some more problems added. 89 I t i s h a r d f o r the d i v i s i o n s to.-agree on the r a t e of r e t u r n on investment, e s p e c i a l l y , i n the. case of d i v i s i o n s w i t h a d i f f e r e n t asset.mix, i . e . , a s s e t s purchased at v a r i o u s times and p r i c e l e v e l s . The main advantage o f t h i s method i s t h a t the d i v i s i o n manager i s f o r c e d to t h i n k i n terms o f the r e t u r n on investment. However, d i v i s i o n s n e a r e s t to the f i n a l market, i f t h e r e i s a s u c c e s s i o n of t r a n s f e r s , might f i n d i t u n p r o f i t a b l e to make s a l e s t h a t would b r i n g l e s s revenue than t h e i r c o s t s , even though the company as a whole may p r o f i t by i n c r e a s e d s a l e s . The weaknesses of the c o s t p l u s a r e t u r n on investment method cumulate; t h e i r impact f a l l s on the d i v i s i o n which deals w i t h the e x t e r n a l market. The method i s bound to be a r b i t r a r y . T r a n s f e r s a t market p r i c e s . T r a n s f e r s at market p r i c e s , though b e t t e r than t r a n s f e r s a t c o s t or a t c o s t p l u s a r a t e of r e t u r n on investment method, have a number of d i s -advantages. P u b l i s h e d market p r i c e s may not be the b e s t g u i d e , because t h e y might be j u s t nominal p r i c e q u o t a t i o n s or inadequate as to q u a l i t y , t i m i n g , and l o c a t i o n of p r o d u c t s . I f the f l o w of goods t r a d e d o u t s i d e the company i s s m a l l e r i n comparison w i t h intra-company t r a n s a c t i o n s , the market does not o f f e r a r e a l a l t e r n a t i v e . . A l s o , i f d e a l i n g s w i t h o u t -s i d e market are not p e r m i t t e d , the t r a n s f e r s become a u t h o r -i t a r i a n . T h i s l i m i t s the u t i l i t y o f the r a t e o f r e t u r n on investment i n performance e v a l u a t i o n . ,.: C o n c l u s i o n . The c o n c l u s i o n seems to be t h a t com-p e t i t i v e l y n e g o t i a t e d t r a n s f e r p r i c e s have the l e a s t number of d i s a d v a n t ages and, t h e r e f o r e , are the b e s t . The compet-. 9 0 i t i v e l y n e g o t i a t e d t r a n s f e r p r i c i n g p r e s e r v e s independence of o p e r a t i n g d i v i s i o n s and p r e s e n t s a m e a n i n g f u l measure of economic performance. The system e l i m i n a t e s u n p r o f i t a b l e d i v i s i o n s by means of d i v i s i o n buyers and. s e l l e r s p u r c h a s -i n g or s e l l i n g o u t s i d e the company. C o m p e t i t i o n to make the b e s t p r o f i t showing encourages hard-headed n e g o t i a t i o n ; and the promotion of mutual economic i n t e r e s t s l e a d s , as always, to c o - o p e r a t i o n . N e g o t i a t e d t r a n s f e r ' p r i c e s can be.used i r r e s p e c t i v e of whether t h e r e i s a market p r i c e or n o t . 'On-the o t h e r hand, t r a n s f e r s at market p r i c e s can be u t i l i z e d o n l y i f market q u o t a t i o n s can be o b t a i n e d . .. . Other methods f o r s e t t i n g t r a n s f e r p r i c e s are inadequate. They keep many l o s s e s h i d d e n and.may have a n e g a t i v e v a l u e i n the making of m a n a g e r i a l d e c i s i o n s . II. LEASING OF FACILITIES D i v i s i o n a l performance may be improved by s e l l i n g and l e a s i n g the f a c i l i t i e s used by the d i v i s i o n , but, a t the same.time, t h i s may r e s u l t i n a lower r a t e of r e t u r n f o r the. company as a whole. T h i s can happen i f the d i v -i s i o n ' s r a t e of r e t u r n i s h i g h e r than the l e s s o r ' s i n t e r e s t and p r o f i t i n c l u d e d i n the r e n t , but, a t the same time, the company's c o s t o f c a p i t a l i s lower than the l e s s o r ' s c a p i t a l c h a r g e s . Under these c i r c u m s t a n c e s , the manager can improve 91 h i s r e t u r n on investment by r e d u c i n g h i s investment base by g r e a t e r percentage t h a n h i s income., From the company's p o i n t of view, t h i s i s u n p r o f i t a b l e ; i t s c o s t of c a p i t a l i s lower than the i n t e r e s t charged i n r e p e a l s . The c o n f l i c t can be a v o i d e d by i n c l u d i n g a c a p i t -a l i z e d v a l u e of the l e a s e d f a c i l i t i e s , i n the d i v i s i o n ' s investment base. The c o n f l i c t a r i s e s , mainly, because on the d i v i s i o n a l l e v e l , the o p e r a t i n g . a c t i v i t i e s are s e p a r a t e d "from the f i n a n c i a l management, i.e.:, source of c a p i t a l , and because l e a s i n g a f f e c t s the company's c r e d i t . The problem can be p a r t i a l l y s o l v e d by c h a r g i n g " d i v i s i o n s w i t h the company's c o s t of c a p i t a l and e v a l u a t i n g performance i n terms? o f c o n t r i b u t i o n income.* It. seems r e a s o n a b l e , however, t o expect t h a t top management w i l l want to r e t a i n c o n t r o l of l e a s i n g , e s p e c i a l l y o f major l e a s e s . I l l .INVESTMENT. DECISIONS AT DIVISION LEVEL I f the d i v i s i o n a l o p e r a t i n g r a t e . of.'return i s h i g h e r than the p r o j e c t e d r a t e of r e t u r n on contemplated investment, the d i v i s i o n manager w i l l not make the d e c i s i o n to i n v e s t . . V a r i o u s d i v i s i o n s may have d i f f e r e n t r a t e s o f r e t u r n ; one may have 20 per cent, the o t h e r 30 p e r cent r e t u r n on i n -vestment; these r a t e s of r e t u r n w i l l s erve as.minimum a c c e p t -a b l e r a t e s i n c o n s i d e r i n g v a r i o u s i n v estments. F o r a d i v -i s i o n e a r n i n g 30 per cent r a t e of r e t u r n , any investment ' 1 ' F o r f u r t h e r d i s c u s s i o n see W i l l i a m Rotch, "Return on Investment as a Measure of Performance" (Unpublished', D o c t o r ' s d i s s e r t a t i o n Harvard U n i v e r s i t y , 1958), Appendix. 92 whose expected r a t e o f r e t u r n i s , lower t h a n 30 per cent w i l l be r e j e c t e d . S i m i l a r l y w i t h a d i v i s i o n , e a r n i n g 20 p e r cent r a t e o f r e t u r n — the expected r e t u r n o f 19 per cent on new investment w i l l lower the o v e r a l l d i v i s i o n a l r a t e o f r e t u r n and w i l l , t h e r e f o r e , not.be a c c e p t e d . I f the company's r a t e o f r e t u r n , i s 25 per cent,, a new. investment w i t h the expected r e t u r n o f , say, 23 per cent i s l i k e l y t o be a c c e p t e d by the d i v i s i o n w i t h the c u t - o f f r a t e o f 20 p e r cent, but i t i s p r o b a b l y not g o i n g to be a c c e p t e d by t h e . t o p management. The problem is-more s e r i o u s w i t h a. h i g h r e t u r n d i v i s i o n ; investments a c c e p t a b l e to the company are l i k e l y to be r e j e c t e d by i t . The c o n f l i c t r e s u l t s from d i f f e r e n c e s i n the c o s t of c a p i t a l between d i v i s i o n s and the company. The r a t e o f r e t u r n o n . d i v i s i o n a l investment c o n s t i t u t e s the c o s t o f c a p i t a l o f the d i v i s i o n . The c o n f l i c t can be p a r t i a l l y s o l v e d by r e v i e w i n g investment d e c i s i o n s contemplated by the d i v i s i o n manager o r by c h a r g i n g the d i v i s i o n w i t h the company's c o s t o f c a p i t a l based on the. d i v i s i o n a l t o t a l investment.. I n the l a t t e r case, the p e r f o r m a n c e . i s measured by t o t a l income a f t e r the i n t e r e s t charge. T h i s , however, ceases to be a r a t e o f r e t u r n on investment measure. LIMITATIONS OP THE RATE OP RETURN ON INVESTMENT IN EVALUATING PERFORMANCE M a n a g e r i a l performance i s the r e s u l t o f many f a c t o r s . Some of them were enumerated i n Chapter I. Income was 93 •assumed to be the p r i m a r y g o a l o f b u s i n e s s a c t i v i t y and the r a t e of r e t u r n on i n v e s t m e n t t h o u g h r e f l e c t i n g m a n a g e r i a l performance i n p r o f i t terms, may not r e f l e c t m a n a g e r i a l performance i n terms o f the achievement o f o t h e r b u s i n e s s o b j e c t i v e s . But even the achievement of p r o f i t g o a l i s not measured i d e a l l y by the r a t e of r e t u r n on investment. F i r s t o f a l l , though t h e o r e t i c a l d e f i n i t i o n o f income may be advanced, measurement o f income i n p r a c t i c e i s an immense p r o p o s i t i o n . E x i s t e n c e of a m u l t i p l i c i t y o f a c c o u n t i n g methods, each p r o d u c i n g d i f f e r e n t income f i g u r e s , t e s t i f i e s t o the magnitude o f the problem. Secondly, d e f i n i t i o n o f the investment base i s f r o u g h t w i t h many d i f f i c u l t i e s , m a i n l y , on account o f i m p o s s i b i l i t y of i d e a l matching of c o s t and revenue and, a l s o , because of the problem of v a l u a t i o n o f a s s e t s . Very important i n t h i s c o n n e c t i o n i s the problem of p r i c e l e v e l f l u c t u a t i o n s . A f t e r a p e r i o d o f i n f l a t i o n , l o n g -l i f e p r o p e r t y i s a mixture of a s s e t s a c q u i r e d a t s u b s t a n t i a l l y d i f f e r e n t p r i c e l e v e l s . D i v i s i o n s w i t h an o l d e r a s s e t mix w i l l have a lower h i s t o r i c a l c o s t investment base than younger d i v i s i o n s and a l s o lower d e p r e c i a t i o n c h a r g e s . T h i s i n t r o d -uces some d i s t o r t i o n s i n t o comparison between d i v i s i o n s and i n t e r p e r i o d comparisons f o r a s i n g l e d i v i s i o n . Comparisons between companies are s i m i l a r l y d i s t o r t e d . Indexes of p r i c e l e v e l changes can be used to r e -s t a t e a s s e t v a l u e s and d e p r e c i a t i o n charges i n d o l l a r s of comparable s i z e , but the v a l u e of t h i s s t e p i s open to q u e s t i o n . 94 I t was suggested t h a t t h i s problem can be a v o i d e d , to a c e r t a i n e x t e n t , by a d j u s t i n g m a n a g e r i a l performance standards to i n d i v i d u a l s i t u a t i o n s and by t a k i n g p r i c e l e v e l changes i n t o a ccount. T h i s i n v o l v e s judgment and, t h e r e f o r e , l e s s e n s the u s e f u l n e s s of e v a l u a t i o n i n terms o f the r a t e o f r e t u r n . The q u e s t i o n o f standards i s c r u c i a l i n e v a l u a t i o n s . An i d e a l s t a n d a r d must p o i n t to what a r a t e o f r e t u r n on investment s h o u l d be under c e r t a i n c o n d i t i o n s . Standards used a t the«present. time are., main l y , a r e v i e w o f p a s t h i s t o r y ; and p a s t performance i s not n e c e s s a r i l y the b e s t p o s s i b l e performance t h a t b o t h the top and.the d i v i s i o n management s h o u l d f o l l o w . CHAPTER IZ 95 CONCLUSIONS OP THE STUDY The primary purpose.of the r a t e of r e t u r n on investment i s to, guide d i v i s i o n a l managers i n t h e i r perform-ance and to help top management i n e v a l u a t i n g i t s own and the d i v i s i o n a l - p e r f o r m a n c e . I n e v a l u a t i n g performance, the top management must con s i d e r and d i s t i n g u i s h between the performance over which d i v i s i o n a l managers have c o n t r o l and t h a t a t t r i b u t a b l e to other u n c o n t r o l l a b l e f a c t o r s . Next, the top management must e s t a b l i s h standards. These ar e , u s u a l l y , determined by com-par i s o n s .with other companies and d i v i s i o n s i n the same i n d u s t r y . The standards must be considered o n l y as gu i d e -posts and not as some immutable t r u t h s . Managerial judgment must always be used. Performance standards must be made known to those concerned so t h a t they know what to maximize. Despite the l i m i t a t i o n s l i s t e d i n the preceding chapter, the r a t e of r e t u r n on investment i s considered to.be a u s e f u l method i n e v a l u a t i n g managerial performance. I t does not e l i m i n a t e judgment completely.from e v a l u a t i o n , but i t does l i m i t the area of judgment and i s , t h e r e f o r e , more o b j e c t i v e , and a l l - e m b r a c i n g than a n y t h i n g t h a t has been used h i t h e r t o . I n a d d i t i o n to income and' s a l e s , the r a t e of r e t u r n measure i n c l u d e s investment. I t measures the e f f e c t i v e n e s s w i t h which 96 management handled the r e s o u r c e s e n t r u s t e d to i t s c a r e and p o i n t s t o . t h e areas where the performance can he improved. The p s y c h o l o g i c a l i n f l u e n c e of the r a t e of r e t u r n on i n v e s t -ment, e s p e c i a l l y when i t i s c o u p l e d w i t h . p r o p e r i n c e n t i v e s , s h o u l d not he o v e r l o o k e d as i t may r e s u l t i n an improved performance. • ®n the company l e v e l , the r a t e of r e t u r n on' investment can be used i n e v a l u a t i n g t o p management, p r o v i d e d u n c o n t r o l -l a b l e , i n f l u e n c e s are e l i m i n a t e d from performance. . On the d i v i s i o n a l l e v e l , the r a t e of r e t u r n does not a d e q u a t e l y r e -f l e c t m a n a g e r i a l performance, u n l e s s c e r t a i n c o n d i t i o n s are f u l f i l l e d , i . e . , the d i v i s i o n a l boundaries are p r o p e r l y marked o f f , t r a n s f e r p r i c e s are' e s t a b l i s h e d , c o n t r i b u t i o n p r o f i t s p r o p e r l y measured, r e a l i s t i c s t andards s e t , e t c . G e n e r a l l y , the c o n c l u s i o n seems to be t h a t the r a t e of r e t u r n on investment i s a good measure to use i n e v a l u a t -i n g performance ; however, s p e c i a l c h a r a c t e r i s t i c s o f each s i t u a t i o n and l i m i t a t i o n s i n h e r e n t i n the method s h o u l d always be born i n mind. I t must be remembered t h a t the r a t e o f r e t u r n on investment i s not the s i n g l e a l l - p u r p o s e , a l l -r e v e a l i n g f i g u r e ; n e i t h e r i s i t a p r e c i s e f i g u r e . Par more r e s e a r c h i n t h i s a r e a i s n e c e s s a r y than has been done h i t h e r t o to make the r a t e o f r e t u r n on investment a r e l i a b l e measure o f performance. I t i s d o u b t f u l w h e t h e r - a - s i n g l e f i g u r e c a n ' ever answer a l l the m a n a g e r i a l problems. What i s r i g h t f o r one purpose may be e n t i r e l y wrong f o r a n other. I n a b u s i n e s s e n t e r p r i s e which i s a c o m p l i c a t e d organism o p e r a t i n g i n a complex w o r l d , the e x e c u t i v e s ' • . 97 s e a r c h f o r a magic f o r m u l a which e l i m i n a t e s judgment must he doomed to f a i l u r e . The r a t e 'Of r e t u r n on investment, a l t h o u g h simple to understand, has i t s l i m i t a t i o n s ; these were p o i n t e d out and d i s c u s s e d i n t h i s paper. N e v e r t h e l e s s , the r a t e o f r e t u r n measure can he of g r e a t h e l p to.management i n e v a l -u a t i n g performance and d e c i s i o n m a k i n g . I t i s an approx-imate measure, hut i t has s e v e r a l important advantages — ( 1 ) i n c l u s i o n and c o n s i d e r a t i o n of the most important f i g u r e s i n "business, s a l e s , investment, and income, and ( 2 ) the speed w i t h which i t can he produced. These are o f g r e a t s i g n i f i c a n c e - to management whose f u n c t i o n and a r t must remain making i r r e v e r s i b l e d e c i s i o n s on the b a s i s of the b e s t Information a v a i l a b l e . BIBLIOGRAPHY 99 BIBLIOGRAPHY I BOOKS. Anthony, Robert N. Management Accounting.. Homewood, I l l i n o i s : R i c h a r d D. I r w i n , I n c . , 1956. 511 pp. Buckley, Henry B. (Lord Wrenbury). .The - Law and P r a c t i c e  under the Companies: A c t . E l e v e n t h edition,••London: Stevens, 1930. p. 75oT~ Dean, J o e l . M a n a g e r i a l Economics. Englewood C l i f f s , New J e r s e y : P r e n t i c e - H a l l I n c . , 1951. XIV + 621 pp. Gardner, Fred V. P r o f i t Management•and C o n t r o l . New York: McGraw-Hill Book Company, In c . , 1955. 285 pp. K e l l e r , I . Wayne. Management Accounting f o r P r o f i t C o n t r o l . New York: McGraw-Hill Book Company,~Tnc., 1957. XXIV. K o h l e r , E r i c . A D i c t i o n a r y f o r Accountants. New York: P r e n t i c e - H a l l I n c . , 1953. p. 179. O r i g o , I r i s . The Merchant of P r a t o : F r a n c i s c o • D i Marco D a t i n i 1335-1410. London: Jonathan Cape, 1957. p.76 and p. 102. Paton, W.A. and A«C« L i t t l e t o n . An I n t r o due t i o n to Corporate. Accounting Standards..American Accounting A s s o c i a t i o n Monograph No. 3> 1957. I I UNPUBLISHED MATERIALS Rotch, W i l l i a m . "Return on Investment as a Measure of Performance," Unpublished Doctor of Business A d m i n i s t r a t i o n T h e s i s , Graduate School of Business A d m i n i s t r a t i o n . George F. Baker Foundation, Harvard U n i v e r s i t y , December, 1958. 100 I I I ARTICLES A.M.A. Financial'Management S e r i e s No. 94. "How'the Du Pont O r g a n i z a t i o n Appraises I t s Performance," by T.C. Davies. New York, 1950. F i n a n c i a l Management S e r i e s No. 103. " I . Return on Investment," by E a r l J . W i p f l e r . New York, 1952. • F i n a n c i a l Management S e r i e s No. 103. • "A Program of F i n a n c i a l Planning- and C o n t r o l s : The Monsanto Chemical Company." New York, 1952. .. F i n a n c i a l Management S e r i e s No. 106.. "How H.J., Heinz Manages I t s F i n a n c i a l Planning- and C o n t r o l s , " by . T.G. MacKensen. New York, 1953. . F i n a n c i a l Management S e r i e s No. 111. "Return on Investment - - t Operating R e t u r n on Operating Investment,", by P a u l ¥.-. Lyon. New York, 1956. . F i n a n c i a l Management S e r i e s No. 111. . "Return .on Investment- — Tool of Modern Management — B a s i c Theory and A p p l i c a t i o n , " by Fred J . Muth. New York, 1956. . General Management S e r i e s No. 176. ""New'Management Tools •-- And What Manager Can Expect of Them," by P e t e r P. Drucker. New York, 1955. . General Management S e r i e s No. 183. "The Return on Investment Concept as a Tool f o r D e c i s i o n Making," by Charles R. Schwartz. New York, 1956. Bierman, H a r o l d J i "Problem i n Computation and Use of Return on Investment," .N.A.A. B u l l e t i n , December, 1957. B r o d e r i c k , P a u l E. " T e s t i n g the P o t e n t i a l of a Company P r i o r to A c q u i s i t i o n , " N.A.A. B u l l e t i n , December, 1958. Brown, Donaldson. "Pricing- P o l i c y i n R e l a t i o n to F i n a n c i a l C o n t r o l s , " Management and A d m i n i s t r a t i o n , February, 1924. -101 Casson, Thomas Hi "Return on Investment," The C o n t r o l l e r , September, 1954. -Chiuminatto, P.M. " P r i c i n g f o r Return on Investment," N.A.C.A. B u l l e t i n , December, 1954. . " S a t i s f y i n g your Company's Need f o r C a p i t a l and Employing i t E f f e c t i v e l y , " N.A.A. B u l l e t i n , September, 1957. Cook, P a u l ¥., j r . " D e c e n t r a l i z a t i o n and the T r a n s f e r P r i c e Problem," J o u r n a l of Business, A p r i l , 1955. Crowe, John W. " C o n t r a s t i n g Concepts of Return on Investment," Canadian Chartered Accountant, February,- 1958. Dean,-Joel. "An Approach to I n t e r n a l P r o f i t Measurement," N.A.A. B u l l e t i n , March, 1958. _. " D e c e n t r a l i z a t i o n and Intracompany P r i c i n g , " Harvard Business Review*, July-August, 1955. " P r o f i t Performance Measurement of D i v i s i o n Managers," The C o n t r o l l e r , September, 1957. . " P r o f i t a b i l i t y Indexes f o r C a p i t a l Investment," -The- C o n t r o l l e r , February, 1958. - . Edson, Harvey 0. "Return on Investment (ROI) as a Measure of Management E f f i c i e n c y , " The C o n t r o l l e r , June, 1957. • . . " S e t t i n g a Standard f o r your Company's Return on Investment," The C o n t r o l l e r , September, 1958. Evans, M.K.' "Accounting Problems i n Measuring Performance by O r g a n i z a t i o n a l Units,"N.A.C.A. B u l l e t i n , August, 1955. Freeman, E. Stewart. "Measuring S a l e s , Gross Assets and Invested C a p i t a l and Comparing them to P r o f i t s , " The  C o n t r o l l e r , February, 1955* Heinaman, Stephen T. "Return on Investment:• Approach to Inventory," N-.A.C.A. B u l l e t i n , J u l y , 1955. 102 H a r r i s , W i l l i a m B. "Pressure on P r o f i t s , " • Fortune., November, 1957.- -K e l l e r , I . Wayne. "The Return on C a p i t a l Concept," • N.A.A. B u l l e t i n , March, 1958. K u t v i r t , 0 t a k e r . " D e p a r t m e n t a l i z a t i o n of Return on Investment," N.A.C.A. B u l l e t i n , - A p r i l , 1959. Lammie, H.R. "Return on C a p i t a l Employed," J o u r n a l of Accounting,. August, 1958. . "Return on C a p i t a l Employed as a Y a r d s t i c k f o r A p p r a i s a l , " N.A.A. B u l l e t i n , November, 1959. Linds e y , David H.- "Two Problems i n A n a l y s i s of Return on Investment,". N.A.C.A. B u l l e t i n , February, 1956., May, George 0. "Concepts of Business Income and T h e i r Implementation," The Quarterly. J o u r n a l of Economics, : February,' 1954•-May, P a u l A." "The Need f o r P r o f i t E v a l u a t i o n f o r Sub-d i v i s i o n s of a. Company," N.A.A. B u l l e t i n , September, 1957. M o l l e r , „G. "Try Budgeting•for Return on C a p i t a l Employed," The C o n t r o l l e r , March, 1958. . . . . . "Measuring Management Performance," Cost, and  Management (Canada), March, 1958. Muth, Fred J . •"Return on C a p i t a l Employed — Measure of Management," N.A.C.A. B u l l e t i n , " February, 1954. . . -"Measurement of Return on C a p i t a l Employed b y ' P r o f i t Centers," Cost and Management (Canada), January, 1957.. » P a t t o n , Arch. "How to Appraise E x e c u t i v e Performance," Harvard Business Review, January - February, I960. 103 Pepke,.Walter. "Profit Package,",Porbes, October-1, 1958. Read, Russel B. "Return on Investment -- A Guide to. Management Decisions," N.A.C.A. Bulletin, June, 1954. Return on Capital as a Guide to Managerial Decisions. NTA.A. Research Report 35, 1959. Return on Investment; Gist of a Technical Service Survey. N.A.C.A. Bulletin, February, 1954. Rushton, James H. "Pricing to Maximize Return on Investment," The Controller, March, 1955. Seed, Allan H. "Capital Turnover-— Key to Capital Management,", N.A.A. Bulletin, June, 1958. Sheehan, Daniel W. "Relation of Invested Capital to Pr o f i t , " The Controller, October, 1956.; Shillinglaw,.Gordon. "Guides to Internal Profit Measurement," Harvard Business Review, March - Apr i l , 1957. Some Variation in Construction and Use of Return on Investment. Based on N.A.A. Technical Service Accounting Procedure Survey No. 1648,. N.A.A. Bulletin, March, 1958. Strong, W.L. "Decentralized Operation, A Control Program," The. Controller, January, 1958. Vatter, William J . "Does the Rate of Return Measure Business Efficiency ?" N.A.A. Bulletin, January,.1959. . V i l l e r s , Raymond. "Control and Freedom in a Decentralized Company," Harvard Business Review, March - A p r i l , 1954. Wright, John W.D. "Setting Earnings Standards for Decentralized Operation,"- The Controller, February, 1957. IV STATISTICAL PUBLICATIONS 104 Moody's I n d u s t r i a l Manual, John Moody, 1959. N a t i o n a l Account Income and Expenditure, 1926-1956. Dominion Bureau of S t a t i s t i c s , 1958? pp. 26-27. Survey of.. Current, B u s i n e s s : 1957 Business S t a t i s t i c s Supplement, p.. 3. The Fortune D i r e c t o r y , The 500 Largest, U.S. I n d u s t r i a l  C o r p o r a t i o n s , Fortune, J u l y , -1959, p.126. A P P E N D I X 106" APPENDIX Three companies i n each of the two chosen Canadian i n d u s t r i e s are compared i n terms of the r a t e of r e t u r n on investment on the i n t r a - i n d u s t r y b a s i s . ' The i n d u s t r i e s chosen a r e : (.1.) I n t e g r a t e d O i l I n d u s t r y , and (2) Paper and P u l p I n d u s t r y . D e f i n i t i o n s of income and investment used i n the comparisons are as advanced i n t h i s paper. Income i s d e f i n e d as the net income of the company, whether r e c u r r i n g or not, but b e f o r e i n t e r e s t on funded debt and income t a x e s . I n v e s t -ment i s d e f i n e d as the t o t a l a s s e t s a v a i l a b l e a f t e r d e p r e c -i a t i o n allowances and o t h e r v a l u a t i o n a c c o u n t s . POP the purpose of comparison, the average of the investment a t the b e g i n n i n g and a t the end o f the p e r i o d i s t a k e n . The f i g u r e s f o r . n e t s a l e s , net income, and average a s s e t s are shown i n thousands. S m a l l d i s c r e p a n c i e s i n the r a t e o f r e t u r n f i g u r e s may a r i s e - d u e to the r o u n d i n g o f f o f the per cent on s a l e s and t u r n o v e r r a t i o . The companies are a n a l y z e d i n terms of the r a t e o f r e t u r n on investment f o r m u l a : Income . - S a l e s = p e r t r e t u r n S a l e s Investment Q n i n v e s t m e n t The p r i n c i p a l s o u r c e s ' o f data used i n computing the r a t e s o f r e t u r n on investment i n t h i s appendix were p u b l i s h e d f i n a n c i a l statements of the companies i n t h e i r annual r e p o r t s to s h a r e h o l d e r s and Moody's I n d u s t r i a l R e p o r t s . 107 I ANALYSIS OF RATES OF RETURN ON INVESTMENT IN PETROLEUM, PRODUCING, REFINING, TRANSPORTING, AND DISTRIBUTING COMPANIES The f o l l o w i n g companies are analyzed i n terms of the r a t e on investment formula: (1 ) Canadian O i l Companies L i m i t e d ( 2 ) Texaco Canada L i m i t e d ( 3 ) B r i t i s h American O i l Company L i m i t e d . Table V I I I , page 1 1 0 , Table I Z, page 1 1 1 , and Table Z, page 1 1 2 , analyze the performance of companies over time, f o r the p e r i o d of f i v e years from 19.54 to 1958 i n c l u s i v e . Table Z l , page 1 1 3 , compares inter-company performance f o r 1 9 5 8 . Canadian O i l Companies.Limited. The performance of Canadian O i l Companies L i m i t e d , as shown i n Table V I I I , page 1 1 0 , i s d e c l i n i n g i n terms of the r a t e o"f r e t u r n on investment. The f l u c t u a t i n g income, as a per cent of s a l e s , and the worsening of turnover r a t i o are c o n t r i b u t i n g f a c t o r s . Income, as a per cent of s a l e s , i n c r e a s e d from 8 . 3 8 per cent i n 1954 to. 1 1 . 2 2 per cent i n 1956 and dropped to 7 . 8 5 per cent i n 1 9 5 8 . On the other hand, the turnover r a t i o d e c l i n e d from . 9 4 i n 1954 to .76 i n 1 9 5 8 . As a consequence., . the r e t u r n on investment decreased from 7 . 8 8 per cent i n 1954 to 5 . 9 7 per cent i n 1 9 5 8 . Comparison w i t h c o m p e t i t i o n , Table X I on page 1 1 3 , shows th a t the company's performance can be improved by i n -c r e a s i n g the asset turnover, i . e . , i n c r e a s e i n s a l e s and more 108 e f f e c t i v e u t i l i z a t i o n of r e s o u r c e s , and an i n c r e a s e i n s a l e s margin. •Texaco Canada L i m i t e d . The a n a l y s i s of the r a t e of r e t u r n on investment of Texaco Canada L i m i t e d i s shown i n Table IX, page 111. The company's r a t e of r e t u r n on i n v e s t -ment i s d e t e r i o r a t i n g . There i s " a marked d e c l i n e a n the company's income as a per cent of s a l e s ; the d e c l i n e i s from 14.73 per cent i n 1954 to 9.88 per cent i n 1958. The company's turnover r a t i o a l s o dropped i n the same period- from 1.13 i n 1954 to 1.09 i n 1958. N e v e r t h e l e s s , of the three companies i n v e s t i g a t e d i n the i n t e g r a t e d o i l i n d u s t r y , Texaco Canada l i m i t e d ranks f i r s t i n terras of the r a t e of r e t u r n f o r m u l a : income as a per cent of s a l e s and turnover (See Table X I , page 113.) This accounts f o r the company's hi g h e r r e t u r n on investment than i n the case of the other two companies. However, measures must be taken to a r r e s t and r e v e r s e the downward t r e n d i n the r a t e of r e t u r n on.investment. D e t a i l e d study of company o p e r a t i o n i s i n d i c a t e d . B r i t i s h American O i l Company L i m i t e d . As shown i n Table X, page 112, the performance of B r i t i s h American O i l Company L i m i t e d i s c h a r a c t e r i z e d by r a p i d l y decreasing ratio;.-of income to s a l e s and turnover of a s s e t s . I n . f a c t , of the three companies considered here, B r i t i s h American O i l Company L i m i t e d presents the poorest p i c t u r e of performance. (See Table X I , page 113.) Improvements i n both r a t i o s , income to s a l e s and s a l e s to a s s e t s , are needed to b r i n g the company to par w i t h the other two companies. 109 C o n c l u s i o n s . More i n f o r m a t i o n i s needed about s p e c i f i c c h a r a c t e r i s t i c s o f each company i n o r d e r to a r r i v e a t sound c o n c l u s i o n s about the i n d i v i d u a l company performance. E x a m i n a t i o n of T a b l e s , V I I I , IX, and X, h o w e v e r , i n d i c a t e s t h a t the t h r e e companies are f a c e d w i t h the same problem, i . e . , a d e c l i n i n g r a t e o f r e t u r n on investment. I t may be, t h e r e -f o r e , t h a t some e x t e r n a l and u n c o n t r o l l a b l e f o r c e s are a t work i n . a l l t h r e e c a s e s . The stud y o f e x t e r n a l f o r c e s , however, i s beyond the scope o f t h i s paper. 1 110 TABLE V I I I RATE OP RETURN ANALYSIS CANADIAN OIL COMPANIES LIMITED Year Net s a l e s ($000) Net income ($000) Average" a s s e t s ($000) Income as a p er cent o f s a l e s T u r n -over Per cent r e t u r n on • investment 1954 1955 1956 195.7 1958-58,518 66,197 76,171 84,318 85,928 4,906 6,273 8,554 8,379 6,748 62,479 • 76,869 95,720 104,731 113,695 8.38 9.47 11.22 9.93 7.85 .94 .86 .80 .80 .76 7.88 8.14 9.98 7.94 5.97 111 TABLE IZ RATE OF RETURN ANALYSIS TEZAGO CANADA LIMITED Year Net •sales ($000) Net • income ($000) Average asset s ($000) Income as a per cent of s a l e s Turn-over Per cent r e t u r n on investment 1954 1955 1956 1957 1058 101*275 115,121 142,874 18.3,467 17.5,308 14,921 18,114 24,226 2.6,416 17,336 89,411 95,615 12.2,745 154,010 161,342 14.73 ,15.73 16.95 14.39 . 9.88 1.13 1.20 1.16 1.19 1.09 16.64 18.88 19.66 1 7 . 1 2 10.77 112 TABLE Z. RATE OP RETURN ANALYSIS BRITISH AMERICAN OIL COMPANY.LIMITED Net Net Average Income as Turn- Per cent Year s a l e s income a s s e t s a per cent over r e t u r n on ($000) ($000) ($000) of s a l e s investment 1954 242,713 30 , 0 9 5 231,840 12 . 3 9 1.05 13.01 1955 268,556 34,479 253,346 12.83 1.06 13-. 60 1956 278,049 ; 31,068 321,253 11*. 17 .86 9.61 1957 308 , 2 9 0 35,759 402,872 1 1 ' . 5 9 ' .76 8'.8l 1958 318,502 24,381 469,087 7.65 .68 5.20 113 TABLE XI RATE OP RETURN ANALYSIS . INTER-COMPANY COMPARISON.OF RATES OF RETURN ON INVESTMENT FOR 1958 Company Income as a Turn-per cent of over sales Per cent ret u r n on investment Texaco Canada Ltd., (Table IX) 9.88 1.09 10.77 Canadian O i l Companies Ltd., (Table VIII) B r i t i s h American O i l Company Ltd., (Table X) 7.85 7.65 .76 .68 5.97 5.20 114 I I ANALYSIS OF RATES OF RETURN ON INVESTMENT IN PAPER AND PULP COMPANIES The a n a l y s i s of the r a t e s of r e t u r n on investment i s made i n the f o l l o w i n g three companies: (1) A b i t i b i Power and Paper Company L i m i t e d * (2) , St Lawrence C o r p o r a t i o n L i m i t e d (3) Anglo-Canadian P u l p and Paper M i l l s L i m i t e d . Tables X I I , page 117, X I I I , page 118, and XIV, page 119 , analyze the performance of the three companies f o r the p e r i o d from 1954 to 1958 i n c l u s i v e . Table XV, page 120, compares inter-company performance f o r 1958. A b i t i b i Power arnd Paper Company L i m i t e d . T able X I I , page 117, shows t h a t the,company's performance i n the l a s t two y e a r s , 1957.and 1958, d e t e r i o r a t e d a p p r e c i a b l y , both i n terms of income,.as a per cent of s a l e s , and turnover r a t i o . As a consequence, the r e t u r n on investment dropped from 18.48 per cent i n 1956 to 14.43 per cent i n 1957 and to a low of 11.70 per cent i n 1958. I t seems t h a t both net s a l e s and net income d i d not keep up pace w i t h the asset expansion. Table XV, page 120, however, shows t h a t the company takes the f i r s t p l a c e i n income, as a per cent of sales^ and the second p l a c e i n turnover r a t i o r a n k i n g . This puts the company on the top of the l i s t as f a r as the r a t e of r e t u r n on investment i s concerned. N e v e r t h e l e s s , improvements i n 115 "both r a t i o s are p o s s i b l e through a d e t a i l e d examination of the company's o p e r a t i o n s and c o n c e n t r a t i o n on areas of weak-ness, not f o r g e t t i n g , a t the same time., to e x p l o i t f u l l y the company's s t r o n g p o i n t s . St Lawrence C o r p o r a t i o n L i m i t e d . Table. X I I I , page 118, shows a d e t e r i o r a t i o n i n the performance of St Lawrence C o r p o r a t i o n L i m i t e d . The company's income, as a p e r ' c e n t of s a l e s , decreased from a h i g h of. 2.4.15 per cent i n 1956 to a low of 17.28 per cent i n 1958. The company's t u r n o v e r r a t i o dropped from .80 i n 1956 to a low o f .62 in"1958. T h e r e f o r e , the r e t u r n on investment d e c l i n e d from a h i g h o f 19.32 per cent i n 1956 to a. low of 10.71 per cent i n 1958. Table. XV, page 12.0, shows t h a t of the t h r e e companies i n v e s t i g a t e d , St Lawrence C o r p o r a t i o n L i m i t e d i s second i n i t s income, as a per cent of s a l e s , but l a s t i n i t s t u r n o v e r r a t i o ranking.' ; S t e p s , s i m i l a r to those i n d i c a t e d i n the case of A b i t i b i Power and P u l p Company L i m i t e d , must be taken t o a r r e s t the u n f a v o u r a b l e t r e n d i n the company's r e t u r n on investment. Anglo-Canadian.Pulp and Paper M i l l s L i m i t e d . The performance of Anglo-Canadian P u l p and Paper' M i l l s L i m i t e d , as shown i n T a b l e XIV; page 119, d e c l i n e d from 1956 t o 1957 and improved'in 1958f income, as a. per cent of s a l e s , dropped from 21.20 per cent, to 13.46 per cent and i n c r e a s e d to 16.06 per cent i n the y e a r s 1956, 1957, and 1958, r e s p e c t i v e l y . The t u r n o v e r r a t i o , on the o t h e r hand, s t a y e d d u r i n g the whole p e r i o d remarkably unchanged, thus, r e d u c i n g the shock o f wide f l u c t u a t i o n i n income 116 I n inter-company comparison, the company has the h i g h e s t 'turnover r a t i o hut the lowest income as a per cent, o f s a l e s . (See Tab l e XV, page 120.) The i n t e r a c t i o n o f the two f o r c e s puts the company i n the second p l a c e i n the r e t u r n on investment r a n k i n g . Improvements, i n s a l e s a re n e c e s s a r y to b e t t e r the company's p r o f i t a b i l i t y . O o n c l u s i o n s . I n t h i s i n d u s t r y as i n the o i l i n d u s t r y d i s c u s s e d p r e v i o u s l y , the knowledge of the s p e c i a l c o n d i t i o n s s u r r o u n d i n g the i n d u s t r y and the companies i n q u e s t i o n i s n e c c e s s a r y to make p r o p e r e v a l u a t i o n s o f performance and a d v i s e on r e m e d i a l s t e p s . However, the f a c t t h a t the t h r e e companies s u f f e r e d a. d e c l i n e i n t h e i r r a t e s o f r e t u r n i n d i c a t e s the e x i s t e n c e o f some e x t e r n a l and u n c o n t r o l l a b l e economic f o r c e s which e x e r t an important i n f l u e n c e on the performance o f t h e t h r e e companies. 117 TABLE X I I RATE OF RETURN ANALYSES ABITIBI POWER.AND PAPER COMPANY LIMITED Net Net 'Average Income as Turn- Per cent Year s a l e s income a s s e t s a per cent over r e t u r n on. ($000) ($000) ($000) of s a l e s investment 1954 113,998 24,446 155,196 21.44 .73 15.65 1955 123,173 132,498 29,644 160,087 24.06 .76 18.28 1956 32,227 173,999 24.32 .76 18.48 1957 128,199 27,204 188,437 21.22 .68 14.43 1958 123,386 22,211 190,237 18.00 .65 11.70 118 TABLE X I I I RATE OF RETURN ANALYSIS ST LAWRENCE CORPORATION - LIMITED Year Net. s a l e s ($000) Net Average income asset s ($000) ($000) Income as a per cent of s a l e s Turn-over Per cent r e t u r n on investment 1954 1955 1956 1957 1958 59,358 70,727 78,363 75,696' 68 ,9'58 12,089 78,434 ' 1 5 , 3 4 4 84,756 I8,:929 98 , 3 8 8 15/884 114,125 11,920 110,380 20.36 21.69 24.15 20 . 9 8 17.28 .76 .83 .80 .68 .62 15.47 18.00 1 9 . 3 2 14.27 10.71 119 TABLE XIV RATE OF RETURN ANALYSIS ANGLO-CANADIAN PULP AND PAPER MILLS LIMITED Year Net s a l e s ($000) Net " income ($000) Average as s e t s ($000) Income as a per cent of s a l e s Turn-over Per cent r e t u r n on investment 1954 1955 1956 1957 1958 43,373 46,501 49,337 50,994 55,808 9,763 10,965 10", 462 6\865 8,966 57,447. 63,850 68", 418 72,985 77,585 2 2 t 5 l ' ' 23.58 21.20 13.46 16.06 .75 .73 .72 .70 .72 16.88 17.21 15.26 9.42 11.56 120 TABLE XV RATE OF RETURN ANALYSIS INTER-COMPANY COMPARISON OP RATES OP RETURN ON INVESTMENT POR 1958.! Income as Company a per cent of s a l e s Turn-over Per cent r e t u r n on investment A b i t i b i Power and; Paper Company Ltd,., (Table X I I ) 18.00 .,65 11.70 Anglo-Canadian Pu l p and Paper M i l l s , L t d . , (Table XIV) 16.06 .72 11.56 St Lawrence C o r p o r a t i o n L t d . , (Table X I I I ) 17.28 .62 10.71 

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