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UBC Theses and Dissertations

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 o f London ( E n g l a n d ) , 1954 A THESIS SUBMITTED I N PARTIAL FULFILMENT OF THE REQUIREMENTS FOR THE DEGREE OF MASTER OF BUSINESS ADMINISTRATION i n the Faculty of , Commerce and B u s i n e s s A d m i n i s t r a t i o n ' We a c c e p t t h i s t h e s i s as c o n f o r m i n g t o the r e q u i r e d  standards  THE UNIVERSITY OF.BRITISH COLUMBIA " A p r i l , I960.  In presenting t h i s thesis i n p a r t i a l f u l f i l m e n t of the requirements f o r an advanced degree at the U n i v e r s i t y of B r i t i s h Columbia, I agree that the L i b r a r y s h a l l make i t f r e e l y a v a i l a b l e f o r reference and study. I. further agree that permission f o r extensive copying of t h i s thesis f o r s c h o l a r l y purposes may be granted by the Head of my Department or by his representatives. It i s understood that copying or p u b l i c a t i o n of t h i s thesis f o r f i n a n c i a l . gain s h a l l not be allowed without my written permission.  Faculty of Commerce and Business  Administration  The U n i v e r s i t y of B r i t i s h Columbia, Vancouver 8, Canada. Date  A p r i l . I960.  ABSTRACT  This of r e t u r n  on  w i t h which and  paper  i s c o n c e r n e d w i t h the use  investment  i n evaluating  the e n t e r p r i s e  assets  the  diffusion  effectiveness  are used  by b o t h  decentralized  of p r o f i t  companies  r e s p o n s i b i l i t y and  there  there  a common m e a s u r e t o e v a l u a t e t h e o p e r a t i n g a. b u s i n e s s a n d  evaluate  rate  investigated and  overriding  factors.  measuring that  and  i s one  return  on  r e s u l t s of  income,  performance.  i s that  Qh  of business i s p r o f i t ,  the  c a n be the the  under which  e f f e c t i v e l y measure  i t s divisions.  the  investment,  i n v e s t m e n t were f o u n d  paper  to  ratio.was  c h a r a c t e r i s t i c of  o f t h e methods t h a t  investment w i l l  as  units  t o p management.  i n c l u s i o n of  certain conditions  a company a n d  and  investment  of this  evaluating  primary goal  then describes  i s the  c o n t r o l over  conclusion  investment  on  Since the unique  and  i s a need f o r  o f i t s components: s a l e s ,  o f r e t u r n measure  The  of d i v i s i o n  of r e t u r n  definition  of  divisional  is a  company as a w h o l e , as w e l l  i n terms  investment.  rate  the  the performance  , The  on  rate  t o p management.. In large  of  of the  to.be  return used  in  assumption discussion the r a t e  of  performance  iv TABLE OP.CONTENTS CHAPTER I.  II. III.  PAGE  THE PROBLEM, DEFINITIONS.OP TERMS -USED AND QUESTIONS ASKED  . , ,1  Introduction . ' • The P r o b l e m . . . . . . . . . . . . . . . . . Statement o f t h e P r o b l e m . . . . . . . . . . . Importance o f t h e Study . . . . . . . . . . .  1 1 1 2  Scope o f t h e S t u d y . < . . R e s e a r c h Method D e f i n i t i o n s o f Terms Used Operating- E f f e c t i v e n e s s . . . . . . . . . . . Division. . » . Contribution Profits Investment and Income . . . . . .  3 4 4 4 4 4 5  Q u e s t i o n s Asked . . . HISTORICAL BACKGROUND . . . . . . . . . BASIC THEORY OP RATE OF RETURN.ON INVESTMENT. . .  5 8 13  General.Considerations  . . .  B a s i c Formula:.-. T u r n o v e r and S a l e s M a r g i n A n a l y s i s  13 . . . ;  13 15  S i g n i f i c a n c e o f t h e Rate o f R e t u r n . o n Investment Measure IV.  18  OBJECTIVES AND CONDITIONS FOR EFFECTIVE PERFORMANCE MEASUREMENT AND., EVALUATION. Objectives  o f P e r f o r m a n c e Measurement ,  . . . . .  21 21  v CHAPTER  PAGE 21  V.  VI.  Statement o f O b j e c t i v e s Factors outside Managerial Control C o n f l i c t of Objectives Conditions 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 o f Rate o f .Return, on I n v e s t m e n t Company L e v e l Division Level PROBLEMS OF INCOME DEFINITION General Background. . . Income D e f i n i t i o n f o r Inter-Company ... Comparisons 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. I n t e r e s t Expense, Income Taxes, and O t h e r Expense D e p r e c i a t i o n Expense Conclusion. . . . . . . D e f i n i t i o n s o f Income f o r Intra-Company Comparisons . . . . . . . PROBLEMS OF INVESTMENT DEFINITION D e f i n i n g I n v e s t m e n t f o r Inter-Company Comparisons . . . . . . D e f i n i n g t h e I n v e s t m e n t Charged t o Divisions A l l o c a t i o n o f Assets t o D i v i s i o n s F i x e d Assets . . . . . . .  . • • •  .  23 24  24 25 26 29 29 35 36 37 39 46 41 44 44 48 52 54  vi CHAPTER  PAGE Background . . C h o i c e o f Gross o r Net P i x e d A s s e t s Inter-Company and Intra-Company Comparisons . C u r r e n t Rate o f R e t u r n R e f l e c t i o n o f P e r f o r m a n c e Changes i n the Rate o f R e t u r n on Investment  54 57 59 61 65  E f f e c t o f Gross o r N e t " A s s e t s on.Rate o f R e t u r n on Investment VII.  $6  .  Conclusions. USES OP THE RATE OP RETURN ON INVESTMENT . . . . Improvement i n P e r f o r m a n c e Through Use o f Rate o f R e t u r n on Investment . . . . . . . . . P r o b l e m s i n E v a l u a t i n g t h e Rate o f R e t u r n on I n v e s t m e n t  71 75  . . . . . . . . . . . .  P e r f o r m a n c e A p p r a i s a l o f a Company . . . . . . . H i s t o r i c a l Comparison o f P e r f o r m a n c e Comparison w i t h C o m p e t i t i o n  78 79 80  Comparison w i t h Well-Managed Companies  81  . . . .  83  A p p r a i s a l o f D i v i s i o n a l Performance VIII.  68 70  SPECIAL PROBLEMS OP THE RATE OP. RETURN ON INVESTMENT . . . . . . . . . . . . . . . . . . .  85  Establishment of Transfer Prices  85  G e n e r a l Background  . . . . . . .  85  ...  Negotiated Transfer Prices  .  86 87  T r a n s f e r s a t Cost 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  '  88  vii CHAPTER  PAGE T r a n s f e r s @,t .Market P r i c e s . Conclusions . Leasing of F a c i l i t i e s  . . . . . . . . . .  89 ;  Investment D e c i s i o n s a t D i v i s i o n L e v e l . . . . . L i m i t a t i o n s o f t h e Rate o f R e t u r n on Investment i n E v a l u a t i n g - P e r f o r m a n c e . . . . .  91 92 95 98  IX. CONCLUSIONS OP THE STUDY. BIBLIOGRAPHY . APPENDIX.  89 90  .  . . V .  .  105  viii L I S T OP TABLES TABLE I. II. III.  PAGE R e t u r n on Investment ,  13  A n a l y s i s of R e t u r n on Investment  15  Comparison of  Rate of  w i t h Rate of IV.  VI.  VIII.  X.  " X " Company f r o m . 79  Comparison w i t h Competition A n a l y s i s of  the  Rate of R e t u r n of  i n the  80 Chosen  .  Same I n d u s t r y  82  Rate of Return A n a l y s i s Canadian O i l Limited .  .  ;  .  110  R a t e o f R e t u r n A n a l y s i s Texaco Canada L i m i t e d .  I l l  .  Rate of Return A n a l y s i s B r i t i s h American O i l Company L i m i t e d  XI.  81  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  Companies IX.  67  t o 1958  Companies VII.  Assets  R e t u r n on Net A s s e t s  R e t u r n on Investment of 1953  V.  R e t u r n on Gross  Rate of R e t u r n  Analysis-..Inter-Company  Comparison of Rate of for  1958  112  . . . . . . .  R e t u r n on Investment 113  ix L I S T OF  TABLES  TABLE , XII.  PAGE Rate  of Return Analysis  Paper XIII.  Rate  Abitibi  Power  and  Company L i m i t e d .  of Return Analysis  117 St Lawrence  Corporation.  Limited XIV.  Rate  118  of Return A n a l y s i s  and P a p e r M i l l s XV.  Rate  L i m i t e d . •-.  of Return Analysis  Comparison  f o r 1958  Anglo-Canadian Pulp 119  Inter-Company  of R a t e s . o f Return.on Investment!  . . . . . . .  . . . . . . .  .  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 o f e v a l u a t i n g m a n a g e r i a l p e r f o r m a n c e . 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 t h e s u c c e s s f u l management o f b u s i n e s s e n t e r p r i s e a r e n o t 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 impression, nor indeed can any s i n g l e y a r d s t i c k o r s t a n d a r d p r o p e r l y measure any s p e c i f i c p e r i o d o f o p e r a t i o n s w i t h o u t some a d a p t a t i o n t o t h e 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 t h e c o m p o s i t e o f many f a c t o r s and each o f 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 t o e v a l u a t e t h e o p e r a t i n g r e s u l t s o f u n i t s o f a b u s i n e s s and t o compare one b u s i n e s s r e s u l t s w i t h those o f other businesses. The management a l s o needs a n 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 p e r f o r m a n c e . II  THE PROBLEM  Statement o f t h e p r o b l e m .  I t was t h e p u r p o s e o f  t h i s s t u d y ( I ) t o examine c r i t i c a l l y t h e r a t e o f r e t u r n on i n v e s t m e n t as a method o f e v a l u a t i n g t h e e f f e c t i v e n e s s w h i c h t h e e n t e r p r i s e a s s e t s a r e u s e d by b o t h and  with  divisional  t o p management; ( 2 ) t o d e f i n e o b j e c t i v e s f o r and t o .  measure t h e a c t u a l o p e r a t i n g r e s u l t s o f d i v i s i o n s and companies;'and ( 3 ) t o p o i n t o u t t h e elements i n a b u s i n e s s s i t u a t i o n w h i c h w i l l be f a v o u r a b l e  and u n f a v o u r a b l e t o t h e  e f f e c t i v e use o f t h e r e t u r n on i n v e s t m e n t as a g u i d e t o b o t h d i v i s i o n a l and t o p management. Importance o f t h e s t u d y . P r e s e n t - d a y r e s e a r c h has defined a t l e a s t eight s i g n i f i c a n t f a c t o r s measuring b u s i ness p e r f o r m a n c e : 1.  Profitability  2.  Market  position  3.  Product leadership  4.  P r o d u c t i v i t y ( e f f e c t i v e use o f c a p i t a l , men, m a t e r i a l s )  5. 6. 7. 8.  P e r s o n n e l development Public responsibility Employee a t t i t u d e s B a l a n c e between l o n g and s h o r t - t e r m g o a l s . 1  A f t e r r e f l e c t i n g on each o f t h e s e c r i t e r i a , t h e i n e v i t a b l e c o n c l u s i o n i s t h 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 , o t h e r w i s e b e i n g number one w i t h i n an i n d u s t r y i n p r o d u c t l e a d e r s h i p , market p o s i t i o n , e t c . , w o u l d make l i t t l e  sense.  T h i s i s based on t h e a s s u m p t i o n  that p r o f i t i s s t i l l the primary o b j e c t i v e o f business a c t i v i t y and t h a t t h e u l t i m a t e g o a l o f management, r e m a i n s the long-term m a x i m i z a t i o n of p r o f i t . A p e r f e c t y a r d s t i c k w h i c h measures q u a n t i t a t i v e l y management's p e r f o r m a n c e w i l l p r o b a b l y n e v e r be f o u n d .  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 t o b u s i n e s s r e s u l t s w i l l c o n t i n u e t o be an a l l - s i g n i f i c a n t _  _  H a r v e y 0. Edson, " R e t u r n on I n v e s t m e n t (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 o f t o p management. Despite the f o r e g o i n g ,  i t s obvious l i m i t a t i o n s and.notwithstanding t h e r e t u r n on i n v e s t m e n t i s c o n s i d e r e d t o  be t h e b e s t common measure o f m a n a g e r i a l e f f e c t i v e n e s s developed thus f a r . Scope o f t h e s t u d y . 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 w h i c h , a t l e a s t f o r a c c o u n t i n g p u r p o s e s , t h e companies a r e d i v i d e d i n t o u n i t s t o w h i c h r e v e n u e s , expenses, and i n v e s t ment a r e a t t r i b u t e d . A l t h o u g h t h e r a t e o f r e t u r n on i n v e s t m e n t c a n be u s e d 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 o f company p e r f o r m a n c e , t h i s s t u d y t a k e s t h e v i e w o f t h e i n t e r n a l management and i n v e s t i g a t e s t h e 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 assets are u t i l i z e d . The to appraise  r a t e o f r e t u r n on i n v e s t m e n t c a n a l s o be used t h e method o f f i n a n c i n g b u s i n e s s  operations.  T h i s i s u s u a l l y t h e r e s p o n s i b i l i t y o f t o p management, and any m a n a g e r i a l e v a l u a t i o n s h o u l d  take i t i n t o account.  Because o f t i m e l i m i t a t i o n s , however, t h e p r o b l e m o f f i n a n c i a l e v a l u a t i o n w i l l n o t be t r e a t e d i n d e t a i l . Two o t h e r s u b j e c t s have an i m p o r t a n t bearing- on the u s e o f r e t u r n on i n v e s t m e n t t o 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 o f the c a p i t a l b u d g e t i n g and t h e p r i c i n g o f t r a n s f e r s between d i v i s i o n s , t h e latter applicable s t r i c t l y  to d i v i s i o n s .  Some s u g g e s t i o n s  w i l l . b e . m a d e f o r a sound s y s t e m o f i n t r a - c o m p a n y t r a n s f e r pricing,. completely  C a p i t a l budgeting-, a l t h o u g h i t cannot be a v o i d e d i n a s t u d y o f t h e use o f r a t e o f 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 p u r p o s e s , w i l l n o t ,  because  of time l i m i t a t i o n s ,  be  treated i n detail, i n  this  study. R e s e a r c h method. literature  on  t o p i c s was  u n d e r t a k e n and  The of  the  Extensive  r a t e o f r e t u r n on  statements  was  a company w i t h . t h a t  industry.(See  to  i s meant  the  DEFINITIONS OP  The  figure  or  therefrom.  a p p l i e d to  a number  attainment  two  overall  companies  perform'  i n the  By  operating  same  effective-  e f f e c t i v e n e s s with which both  effectiveness w i l l i n the  related  TERMS USED  d i v i s i o n a l management h a v e u s e d t h e them.  and  105.)  Operating' e f f e c t i v e n e s s . ness  current  drawn  compare t h e  of.other  a p p e n d i x , page  Ill  finally  the  o f s e v e r a l companies w i t h i n  Canadian i n d u s t r i e s i n order ance o f  of  investment  c o n c l u s i o n s were  r a t e of r e t u r n concept financial  review  of  assets  show i t s e l f other  top  and  entrusted in a  to  profit  s t a t e d sompany  object-  ives . Division. attributed  to the  "divisions" them f r o m  or  the  units,  The  called  d i v i s i o n a l manager w i l l  purchasing,  profits  investments  of the  engineering-,  which a r i s e  out  be  are  hereafter distinguish  to which only p r o f i t s  Contribution profits. those  be  and  " p r o f i t - i n v e s t m e n t - c e n t e r s " to  f u n c t i o n a l operations  production,  profits  they w i l l  "profit-centers"  attributed. for  When b o t h  are  responsible  division,  i . e . , the  sales, etc.  Contribution profits o f matching- o f  costs  are  and  5 r e v e n u e s o v e r w h i c h t h e d i v i s i o n a l manager has I n v e s t m e n t and income.  control.  Investment c o n s i s t s o f  i t e m s on t h e a s s e t s i d e o f t h e c o n v e n t i o n a l b a l a n c e s h e e t . Income i s g e n e r a l l y a n e t income f i g u r e f o r t h e p e r i o d computed under t h e c l e a n s u r p l u s t h e o r y a s s u m p t i o n s .  It is  net  on  o f d e p r e c i a t i o n e x p e n s e s , hut b e f o r e t h e i n t e r e s t  f u n d e d debt and t h e income  taxes.  P r o b l e m s o f i n v e s t m e n t and income d e f i n i t i o n s  will  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 . How evaluating  -  QUESTIONS ASKED  good i s t h e r a t e o f r e t u r n on i n v e s t m e n t i n company and d i v i s i o n a l p e r f o r m a n c e w i l l  depend  on how c l o s e l y i t approaches t h e i d e a l y a r d s t i c k w h i c h t a k e s 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 t h e a r e a s o f good and bad p e r f o r m a n c e .  A  well-made measurement s y s t e m can h e l p management t o see c l e a r l y t h e f i n a n c i a l a s p e c t s o f what t h e company and d i v i s i o n s a r e l i k e , what t h e y have done and what t h e y a r e doing. own  I t c a n a l s o h e l p t h e management t o a r r i v e a t t h e i r  evaluations. The v a l i d i t y o f t h e r a t e o f r e t u r n on i n v e s t m e n t  i n t h e e v a l u a t i o n o f p e r f o r m a n c e w i l l be b r o u g h t out t h e n by the  f o l l o w i n g - q u e s t i o n s :: 1.  Does t h e r a t e o f r e t u r n on i n v e s t m e n t i d e n t i f y good and bad p e r f o r m a n c e and p o i n t t o where p e r f o r m a n c e c a n be  improved?  2.  Does t h e r a t e o f r e t u r n on  investment  measure r e f l e c t t h e e f f e c t o f a l l f a c t o r s required f o r successful operation 3.  ?  Does t h e use o f t h e r a t e o f r e t u r n on i n v e s t m e n t l e a d t o any b e t t e r performance  ?  An a f f i r m a t i v e answer t o t h e s e q u e s t i o n s has c e r t a i n l y been, i m p l i e d i n most o f t h e p u b l i s h e d w r i t i n g ' s on t h e s u b j e c t . Nobody, however, has as y e t d e m o n s t r a t e d t h a t h i g h p r o f i t a b i l i t y and s u c c e s s a r e a d i r e c t r e s u l t o f t h e use o f r a t e o f r e t u r n on i n v e s t m e n t t o measure p e r f o r m a n c e i n d e e d , i t i s d i f f i c u l t t o do s o . N e v e r t h e l e s s , i t may be p o s s i b l e t h r o u g h e x a m i n a t i o n o f a number o f s i t u a t i o n s t o f o r m some v a l i d o p i n i o n as t o w h e t h e r t h i s p r e s u m p t i o n s t a n d s up. The- answers t o t h e s e q u e s t i o n s w i l l be sought i n t h e 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 on i n v e s t m e n t f o r m u l a and i n t h e c o n s i d e r a t i o n o f f a c t o r s i n b u s i n e s s environment f a v o u r t h e e f f e c t i v e use o f t h e r a t e o f r e t u r n on t o measure and e v a l u a t e p e r f o r m a n c e . f a c t o r s may action;  which  investment  A number o f t h e s e  be t h e r e s u l t o f t o p management p o l i c y and  o t h e r s may  be d e t e r m i n e d by c e r t a i n c h a r a c t e r i s t i c s  o f a b u s i n e s s s i t u a t i o n w h i c h a r e n o t c o n t r o l l a b l e by anyone i n the company.  M a n a 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 o f d i v i s i o n a l and company p e r f o r m a n c e terms o f t h e r a t e o f r e t u r n on i n v e s t m e n t s o u n d e r , l i m i t a t i o n s a r e known and t h e s i g n i f i c a n c e o f t h e s e factors i s pointed  out and  understood.  in  i f the various  Attempt w i l l be made t o d e v i s e c e r t a i n b u s i n e s s c o n d i t i o n s , under w h i c h t h e r a t e o f r e t u r n .on i n v e s t m e n t w i l l be most e f f e c t i v e i n m e a s u r i n g d i v i s i o n a l p e r f o r m a n c Management s h o u l d 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 o f b u s i n e s s r e s u l t s no amount o f 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 c o n c e p t o f t h e r e t u r n on i n v e s t m e n t as a measure o f 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 n o t new. According the f o u r t e e n t h  t o I r i s O r i g o , F r a n c e s c o , D i Marco D a t i n i ,  century  "Merchant o f 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 t h e r a t e o f r e t u r n i n s h i f t i n g ' h i s i n v e s t m e n t s f r o m one v e n t u r e t o 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 o f t h e s l o w and s m a l l p r o f i t s o f c l o t h - m a k i n g (computed by P r o f e s s o r P. M e l l s t o be 8.92%) as compared t o most o f h i s o t h e r e n t e r p r i s e s (average o f 28% made d u r i n g s e v e n t e e n y e a r s i n t h e v e i l t r a d e ) d i s c o u r a g e d D a t i n i f r o m t a k i n g any l a r g e r part i n t h i s industry. His c o n t r i b u t i o n to i t , as we have s e e n , was some c a p i t a l and t h e good E n g l i s h and S p a n i s h w o o l w h i c h h i s money bought. But t h e management o f t h e b u s i n e s s r e m a i n e d e n t i r e l y i n t h e hands o f h i s p a r t n e r s , and a f t e r t h e d e a t h f r o m t h e p l a g u e o f b o t h N i c o l o d i G i n u t a and F r a n c e s c o B e l l a n d i n i i n 1400 ( t h e b u s i n e s s p a s s i n g i n t o t h e hands o f N i c o l o ' s son A n g n o l o ) , t h e amount o f w o o l w h i c h D a t i n i bought f o r t h e company g r a d u a l l y d i m i n i s h e d . . . ! I n more r e c e n t  y e a r s management has t r i e d t h e r a t e  o f r e t u r n c o n c e p t i n p r i c i n g , c a p i t a l budgeting-, e t c .  In  1920's D o n a l d s o n Brown, i n h i s c a p a c i t y o f 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 ,  1  made t h e r a t e o f r e t u r n  I r i s O r i g o . The Merchant o f P r a t o , J o n a t h a n Cape, 1957) p.76. P e r c e n t a g e s f r o m on pp. 76 and 102.  (London; : information  9 on i n v e s t m e n t an i n t e g r a l p a r t o f t h e company's p r i c i n g policy.  I n h i s own  words:  An a c c e p t a b l e t h e o r y o f - p r i c i n g "must be t o g a i n o v e r a p r o t r a c t e d p e r i o d o f time a m a r g i n o f p r o f i t w h i c h r e p 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 t u r n o v e r and..the enjoyment o f wholesome e x p a n s i o n , w i t h adequate r e g a r d t o t h e 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 into 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 w h i c h t o gauge the p r i c e o f a commodity w i t h regard to c o l l a t e r a l circumstances a f f e c t i n g s u p p l y and demand.,.- ( h i s i t a l i c s j Not the r a t e o f of i n t e r e s t applying i t  u n t i l about 1948 was t h e r e much w r i t t e n on r e t u r n on i n v e s t m e n t . Since- t h e n , a h i g h l e v e l can be f o u n d i n the r a t e o f r e t u r n measure i n t o many phases o f i n t e r n a l c o n t r o l .  The a d d r e s s o f T.C. D a v i s , the t r e a s u r e r o f du P o n t Company, d e l i v e r e d b e f o r e A.M.A. f i n a n c e c o n f e r e n c e i n 1949, a r o u s e d a w i d e s p r e a d 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 P o n t company has  r e t u r n on i n v e s t m e n t s i n c e 1919. System was  developed.  The  been u s i n g the r a t e I n 1920's t h e  Chart  charts related"the rate  r e t u r n on i n v e s t m e n t o f each d i v i s i o n and  of of  department t o  o p e r a t i n g r e s u l t s o f r e s p e c t i v e d i v i s i o n s and  the  departments  1  D o n a l d s o n Brown, " P r i c i n g P o l i c y i n R e l a t i o n t o 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 , ' F e b r u a r y , 1924, p. 197.  10  i n terms o f the r e v e n u e , expense, and i n v e s t m e n t a c c o u n t s . 1 S i n c e W o r l d War Two, a number o f l a r g e companies has a p p l i e d , t h e r e t u r n on. i n v e s t m e n t as an i n t e r n a l measure o f p a s t performance.' Two s i g n i f i c a n t t r e n d s , t h e 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 t h e i n c r e a s e d r a t e o f i n v e s t m e n t , have c o n t r i b u t e d t o t h e i n c r e a s e i n u s e f u l n e s s o f t h e r a t e o f r e t u r n on i n v e s t m e n t concept.. The d e c e n t r a l i z a t i o n o f management and t h e a t t e n d a n t 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 r e q u i r e d some check on t h e o v e r a l l performance o f autonomous s u b - u n i t s o f a company. The r a t e o f r e t u r n on i n v e s t m e n t measured o v e r a l l p e r f o r m ance and t h e r e f o r e answered t h e r e q u i r e m e n t s o f t h e d e c e n t r a l ized organization. The b u s i n e s s made more i n v e s t m e n t a f t e r t h e war than.had been made f o r many y e a r s .  Gross p r i v a t e d o m e s t i c  i n v e s t m e n t i n t h e U n i t e d S t a t e s a v e r a g e d 8.2.per c e n t o f the Gross N a t i o n a l P r o d u c t i n t h e . p e r i o d f r o m 1930-1939 and from 1945-1954 i t averaged 13•9 o f 18 p e r c e n t i n 1 9 5 0 .  2  p e r c e n t , r e a c h i n g a peak  I n Canada, b u s i n e s s g r o s s  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 f r o m 1930-1939 i t averaged 1 0 . 4 averaged 16.7  per cent, from 1945-1954 i t  p e r c e n t , w i t h the peak i n the l a t t e r  period  —  T.C. D a v i s , "How t h e du Pont O r g a n i z a t i o n A p p r a i s e s I t s P e r f o r m a n c e , " (New Y o r k : A m e r i c a n 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 S u r v e y o f C u r r e n t B u s i n e s s : 1957 B u s i n e s s S t a t i s t i c s Supplement, p . 3 «  11 o f 20 p e r c e n t i n 1953> i n c r e a s i n g t o 22.1 p e r c e n t i n 1956.  -j W i t h t h e a c c e l e r a t e d g r o w t h o f i n v e s t m e n t , i t  became more i m p o r t a n t t o i n c l u d e t h e i n v e s t m e n t f a c t o r i n t h e measure o f p e r f o r m a n c e .  The r a t e o f r e t u r n on i n v e s t -  ment measured b o t h p r o f i t s and i n v e s t m e n t . 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 o f r e t u r n on i n v e s t m e n t l o s e s s i g n i f i c a n c e . O t h e r s , l i k e I . Wayne K e l l e r , t h e C o n t r o l l e r o f A r m s t r o n g Cork Company, a r e e n t h u s i a s t i c s u p p o r t e r s o f t h e r a t e o f r e t u r n on i n v e s t m e n t . K e l l e r has t h i s t o s a y about i t : The p r o b a b i l i t y o f 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 t h e y a r e p l a n n e d as a p e r c e n t age o f r e t u r n ' o n c a p i t a l employed t o p r o d u c e them and t h e b u s i n e s s i s managed w i t h t h e o b j e c t i v e o f a c h i e v i n g t h i s p l a n n e d r a t i o . A few A m e r i c a n c o r p o r a t i o n s have u s e d r e t u r n on i n v e s t m e n t on C a p i t a l employed f o r measuri 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 t h e y 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 a t a l l l e v e l s have e n j o y e d 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 d i v i d e n d s 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 compani e s have had o u t s t a n d i n g g r o w t h r e c o r d s , s u p p l y i n g more and more p r o d u c t s a t c o m p e t i t i v e p r i c e s w h i c h c o n t r i b u t e d t o t h e improvement t o t h e economy o f t h e n a t i o n and t h e g e n e r a l standard o f l i v i n g . With t h i s demonstrated r e c o r d o f t h e e f f e c t i v e n e s s o f 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 t o u n d e r s t a n d why companies have been s l o w i n u s i n g I t . . I t i s o n l y r e c e n t l y t h a t 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 t o be u s e d by a g r o w i n g number o f companies. ^ _ N a t i o n a l A c c o u n t Income and E x p e n d i t u r e 1926-1956, D o m i n i o n B u r e a u o f S t a t i s t i c s , 1958, pp. 26, 27. 2 I . Wayne K e l l e r , Management E o r P r o f i t C o n t r o l (New Y o r k : M c G r a w - H i l l , 1 9 5 7 p . 313. :  12 It  is possible  rate  that  that  the  that  i t i s the  with  j u s t average p r o f i t s  exerting use  o f r e t u r n on key  to  themselves  of r e t a i n e d  of going  to  many managements do investment  success. and  i n pursuit  earnings  important  and  i t can  measurement and still  a rather  business  evaluation  still  be  their or  content  the  need  profits.  conservative  top  on  of Increased  e x p a n s i o n and  avoidance have  attitude.  investment  is  an  management c o n t r o l ; somer? and  must  has  therefore  i n evaluating  be  b e e n done i n t h e  of performance; The  e f f e c t s and improve This  Rather,  concept w i l l  on  to  be  the  paper w i l l  a critical  undertaken to  under which the  of  correct  good  area  this  exploration  managerial performance,  conditions  improved.  to  undertaken.  these problems.  certain be  this  obscure subject.  processes,  of r e t u r n is  or  n e c e s s a r y f u n d s , may  lead - astray  research  a c t i o n t o remedy bad  all  feel  higher  of r e t u r n of  be  feel  used  caution.  Very l i t t l e  must  rate  useful part  t i m e s , however, with  of  the market f o r the  Sometimes t h e  not  f o r business  been a c o n t r i b u t i n g f a c t o r to  is necessary  O t h e r s may may  not  of  day  i t is  various  consequent  performance not  t r y to  analysis see and  how  of  solve  the  rate  effective i t  to p o i n t  out  managerial performance  may  13 CHAPTER I I I BASIC  THEORY OP RATE OF RETURN ON  I GENERAL Basic investment  formula*  CONSIDERATIONS  The f o r m u l a  i s the r e s u l t  INVESTMENT  o f two  1.  The p e r c e n t a g e  2.  Turnover.  f o r r e t u r n on  factors:  o f income o n s a l e s , a n d  (Table 1 ) . TABLE 1  Return 1  .  2.  J ,  -r  -p •  n  Income=percentage o f income o n s a l e s  Sales  ,  5  ^  cent  t  m  e  n  $10,000  ^onA nnn=5 p e r *200,0.00 defit $200,000=2 t u r n  Sales ^turnover T  Per  on Investment.  $1UU, OUU cover  t  Income  5 p e r cent  The same r e s u l t ,  on S a l e s x Turnover x 2  t e n per cent  = Return on Investment =10  per cent  on t h e investment  of  $100,000, c a n be o b t a i n e d b y s i m p l y r e l a t i n g ' i n c o m e t o investment. in relation relation  I n doing  s o , however,  the s i g n i f i c a n c e  t o s a l e s and the s i g n i f i c a n c e  t o s a l e s volume  i s obscured.  of costs  of investment  Cost  price  in  relationship  i s shown by t h e p e r c e n t a g e  o f income on s a l e s . Investment  t u r n o v e r measures t h e i n t e n s i t y w i t h w h i c h t h e c a p i t a l i s employed; t o t h e e x t e n t t h a t company c a n match p e r  cent  income on s a l e s o f a c o m p e t i t o r 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 a s . t o have a h i g h e r t u r n o v e r , i t has a compe t i t i v e advantage.  I f i t can a c h i e v e b o t h 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 The  growth.  r e t u r n on i n v e s t m e n t  can be improved i n t h r e e  ways. 1.  By i n c r e a s i n g volume o f s a l e s , . w h i l e m a i n t a i n i n g t h e same income p e r c e n t a g e , o r 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 o f i n v e s t m e n t  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 o f a d d i t i o n s t o 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 o f t h i s f o r m u l a and i t s a n a l y s i s l i e s  i n t h e i n t r o d u c t i o n o f a new income and i n v e s t m e n t .  f a c t o r , sales, i n a d d i t i o n to  I t i s known as a du P o n t f o r m u l a  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 Sales  x  Sales Investment  _  Income Investment  15 It of  i s important  to realize  t h e r e t u r n on investment  analysis. sales  - The r a t i o  to investment  that  t h e breakdown  i s o n l y f o r the purposes  o f income t o s a l e s means l i t t l e  of  or the r a t i o of  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 on  investment  analysing out  and s a l e s m a r g i n  analysis.  formula presents an e f f e c t i v e  changes  The r e t u r n method o f  i n t h e r e t u r n on i n v e s t m e n t  the areas r e q u i r i n g  companies o r d i v i s i o n s  attention.  and i n p o i n t i n g  I t c a n be a p p l i e d t o  i n intra-company  or  inter-company  comparisons.  In Table  I I , the i n t e r r e l a t i o n of sales  income, and i n v e s t m e n t  i s analysed  volume,  i n t h r e e assumed  companies,  TABLE I I Analysis Company A  Sales Income Investment  Company  (line  investment. . B  Company  C  $500,000  $250,000  $5,000,000  50,000  ; 25,,000  25,000  250,000  2,9500,000  2,500.000  10 p e r c e n t  0.5 per cent  Income a s a percentage of sales ( l i n e 2/1 i n e 1.) 10 p e r cent Turnover  o f r e t u r n on  1/line  3)  2  .1  ,2  R e t u r n on Investment ( l i n e 4 x l i n e 5) 20 p e r c e n t  1; p e r c e n t  1 per cent  16  T a b l e I I b r i n g s o u t a number o f i m p o r t a n t f e a t u r e s o f a company's p r o f i t a b i l i t y .  I t p o i n t s o u t t h e 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 t h e income as a p e r c e n t a g e o f s a l e s , w o u l d 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; b o t h have t h e s a l e s m a r g i n o f ten per cent. I t w o u l d a l s o be misleading- t o t h i n k t h a t Company B was more p r o f i t a b l e t h a n Company C w h i c h earned o n l y o n e - h a l f o f one p e r c e n t on i t s s a l e s as a g a i n s t Company B's t e n p e r c e n t s a l e s m a r g i n . A q u i c k l o o k a t t h e r a t e s o f r e t u r n on i n v e s t m e n t w o u l d d i s p e l s u c h 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 t h e same as t h a t o f Company C; b o t h have one p e r c e n t r a t e o f r e t u r n on i n v e s t m e n t w h i c h i s f a r l e s s t h a n t h a t o f Company A e a r n i n g as much as t w e n t y p e r c e n t on i t s investment. I f Companies A and. B a r e i n t h e same i n d u s t r y , i n v e s t i g a t i o n of turnover proved p r o f i t a b i l i t y .  by Company B.may l e a d i t t o i m -  S i m i l a r l y , i f Company A and Company  C a r e i n t h e 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 l o w e r income as a p e r c e n t a g e o f s a l e s " m a y l e a d i t t o h i g h e r profits. Assuming u n i f o r m s e l l i n g p r i c e s i n t h e i n d u s t r y , Company A s h o u l d  n o t be s a t i s f i e d , w i t h t h e income m a r g i n  of t w e n t y p e r c e n t , b u t i t s h o u l d  i n v e s t i g a t e c o s t s and  f i n d ways.to r e d u c e 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 i n v e s t m e n t f o r m u l a assumes t h a t t u r n o v e r and s a l e s m a r g i n (income as a p e r c e n t a g e o f s a l e s ) are i n d e p e n d e n t f a c t o r s . W i t h s u b s t a n t i a l f i x e d expenses  17 this  may n o t he t r u e .  Higher turnover  income as a p e r c e n t a g e is  maintained,  fixed  While contain  increase  this  analysis  irrespective investment  an e n t e r p r i s e  improvements utilization  with  price  large  sales.  i t does,  however,  I t considers  the very handling'  i n t e r m s o f two r a t i o s  of business;  of the r a t e to higher  i n sales, reduction of resources.  and t h e r a t i o  acceptance  increase  Ratios total  rather  are comparable  income a n d  total  are not.  Proper analysis  i n business  Mr. W i l l i a m Profit,"  i s simple  dollar figures.  of the scale  to  the s e l l i n g  f a c t o r o f s a l e s volume, and i t e n a b l e s  t h a n i n terms o f t o t a l  concept  tend  do n o t , w i t h  proportionately  the r e t u r n on investment  may l e a d  of sales  certain useful features.,  important of  of sales, provided  because cost  expenses,  will  has t h i s  of return  profitability of costs,  The r a t e  investment  through  a n d more e f f e c t i v e  of return  analysis are gaining  on  an  on  investment  increased  management.  B. H a r r i s  i n discussing"Pr>essure  on  to say:  T h i s downward t r e n d i n p r o f i t s d e v e l o p e d i n t h e l a t t e r p a r t o f a d e c a d e t h a t , t a k e n a s a w h o l e , shows a n e a r l y i d e a l p r o f i t record 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 t h e f u l l decade 1 9 4 7 - 5 6 , s a l e s r o s e 1 3 6 . 9 p e r cent and p r o f i t s 1 3 6 . 9 p e r c e n t . The e x a c t s i m i l a r i t y i s sheer coincidence, o f course, 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 u s e d t o 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 t h e h i s t o r i c p a t t e r n — 75 c e n t s i n n e t o p e r a t i n g i n v e s t m e n t t o produce $1 i n s a l e s . Thus w h i l e t h e r a t i o o f p r o f i t t o s a l e s r e m a i n i n g u n c h a n g e d f o r t h e g r o u p a s a. w h o l e , p r o f i t r a t i o s o n  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 b a l a n c e o f t h e s e r a t i o s i s a key f a c t o r i n c o r p o r a t e performances P o r a b u s i n e s s t h a t produces h i g h e r and h i g h e r 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 a t t h e 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 e a r n i n g s 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 P o r t h e s e r e a s o n s b o t h the p e r c e n t o f income and the i n v e s t m e n t t u r n o v e r need c l o s e w a t c h i n g t o be see what i s h a p p e n i n g to•company o p e r a t i o n s and where r i a l e f f o r t - needs t o be c o n c e n t r a t e d . B o t h s h o u l d be s t r a t e g i c p o i n t s of c o n t r o l .  on s a l e s able to managethe  The answer t o t h e q u e s t i o n posed a t the b e g i n n i n g o f t h i s p a p e r , o f w h e t h e r the r a t e o f r e t u r n on i n v e s t m e n t r e f l e c t s the e f f e c t o f 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 , i s y e s . The r a t e o f r e t u r n on i n v e s t m e n t measurement does n o t 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 p e r f o r m a n c e : s a l e s , income, and i n v e s t m e n t . I t shows .management s .: e f f e c t i v e n e s s i n h a n d l i n g t h e r e s o u r c e s e n t r u s t e d to i t . 1  I I SIGNIFICANCE OP THE RATE OF RETURN ON INVESTMENT MEASURE The p e r f o r m a n c e o f most b u s i n e s s e s i s e v a l u a t e d by s t o c k h o l d e r s , c r e d i t o r s , and o t h e r 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 , " P r e s s u r e on P r o f i t s , " November, 1957, p. 121.  Fortune,  19 percentage r e t u r n All  enterprises  prises ion  and  the  the  must  top  the  compete f o r c a p i t a l  r e t u r n on  for continuation  Since  company makes on  capital  of.the  capital  with  remains  the  other  company's r a t e  use  the  the  a. g u i d e  logical thing i n i t s actions  of  to  to  do  and  however, i s not  the  any  d e c i s i o n may  based. -.Non-financial  erations  may  be  just  as  assumed, however, t h a t an  important  by  management o f  likely  to  be  guide  is well  important the  top  of  return  and  any  light  It i s  on.investment The  proposed  of  which consid-  as. p r o f i t a b i l i t y .  of r e t u r n  is  decisions.  c r i t e r i o n on  management a c t i o n s .  i n the  their  is  evaluation  action  effect  are  on  the  on: i n v e s t m e n t .  stockholders  expressed  rate  i t s decisions  considered  company's r a t e  How  to  be  only  i n terms  Profitability, particular  criter-  business.  of r e t u r n ,  same y a r d s t i c k , as  enter-  ultimate  management,is'being evaluated  the  invested.  evaluate  a company's  performance  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 c o u n t s 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 e a r n s on i t s c a p i t a l . A company c a n e a s i l y go b r o k e 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 w a n t s t o know i s t h i s : How much a r e t h e e a r n i n g s and how much o f them c a n I g e t ?^  As  stated  before,  market f o r the  supply  the  of  evaluation  of  their  c o m p a n i e s w h i c h do f u n d s may  results  not  temporarily  i n terms o f  the  rely  on  disregard rate  of  return.  1  1958,  W a l t e r Pepke, p.  11.  " P r o f i t Package," Forbes, October  .  1,  However, p r o f i t  i s the l i f e h l o o d  of business;  diminishing  p r o f i t w i l l compel such e n t e r p r i s e s to. c o n c e r n t h e m s e l v e s , s o o n e r o r l a t e r , w i t h t h e r a t e > o f r e t u r n i f t h e y want t o stay i n business.  21 CHAPTER I V  O B J E C T I V E S AND CONDITIONS POR E F F E C T I V E ' PERFORMANCE MEASUREMENT  AND  EVALUATION I  OBJECTIVES- OP PERFORMANCE MEASUREMENT  Statement are  two o b j e c t i v e s  of objectives.  "  J o e l Dean f e e l s t h a t  o f i n t e r n a l performance  there  measurement:  T h e s e arei,: f i r s t , t h e g u i d a n c e o f t h e 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 a r e b e i n g m e a s u r e d a n d , s e c o n d , t h e a s s i s t a n c e o f t o p management and i t s s t a f f i n t h e i r tasks 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 e m p h a s i z e s "and,  aside  simplicity,  t h e s e two o b j e c t i v e s  from such u s u a l l y these are the only  a measurement  c a n be d i g r a m e d  First A.  later,  c h a r a c t e r i s t i c s as  (his italics)  objectives of  system."  J o e l Dean's o b j e c t i v e s ment  desirable  by a d d i n g  of internal profit  measure-  as f o l l o w s :  Objective  —  P o r D i v i s i o n a l Management  To f u r n i s h a g u i d e f o r d i v i s i o n  management.  1 J o e l Dean, "An A p p r o a c h 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 , M a r c h , 1958, p.5.  22 B.  To f u r n i s h a m e t h o d b y w h i c h management  Second A.  of  B.  —  f o r Top  t o p management  divisional  The  this  w i t h managerial performance base f u r t h e r d i s c u s s i o n .  ant.  evaluation  by  pointing  attention.  o f i n t e r n a l measurement  o f p e o p l e and s i n c e  appraisal  i n the  performance.  areas r e g u i r i n g  purposes  performance.  Management  To g u i d e d i v i s i o n a l p e r f o r m a n c e out  terms  c a n e v a l u a t e i t s own  Objective  To a s s i s t  divisional  paper  i twill  are stated i n  concerns  itself.largely  be a c o n v e n i e n t p o i n t  Both' o b j e c t i v e s w i l l  to  be i n v o l v e d i n  of managerial performance; both are equally  import-  A c c o r d i n g t o Dean:  Many v i e w t h e s e c o n d o f t h e s e o b j e c t i v e s , n a m e l y , m e a s u r i n g d i v i s i o n a l p e r f o r m a n c e as i f i t were t h e o n l y one o r a t l e a s t t h e more i m p o r t a n t o f t h e 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 m o s t companies': p r o f i t s a r e a f f e c t e d a t l e a s t as much b y t h e i n f l u e n c e o f a measurement s y s t e m on t h e d a y - t o - d a y b e h a v i o u r o f d i v i s i o n management a s b y t h e a s s i s t a n c e t h e s e m e a s u r e m e n t s g i v e t o t o p m e a s u r e m e n t l a t e r on.^  D i v i s i o n managers w i l l think  i s used t o e v a l u a t e t h e i r  clean  desk,  or p r o f i t .  _ Ibid., p.  5.  use t h a t  y a r d s t i c k which  performance,  i t may  I t is, therefore, important  be  that  they sales  3 p e r f o r m a n c e m e a s u r i n g s t a n d a r d o r s t a n d a r d s a r e w e l l known to t h o s e c o n c e r n e d , o t h e r w i s e d i v i s i o n managers a r e a p t t o maximize w h a t e v e r t h e y 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 c o n c e p t i o n o f what c o n s t i t u t e s a good p e r f o r m a n c e may n o t c o i n c i d e w i t h the t o p management's i n t e n t and r e s u l t i n a c t i o n s n o t i n a c c o r d w i t h company o b j e c t i v e s . 2  1  I . Wayne K e l l e r does n o t d i s t i n g u i s h between t h e two objectives: The purpose o f t h e 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 a r e more s i g n i f i c a n t t h a n p e r c e n t a g e r a t i o s . C o n s i s t e n c y i s o f p r i m e i m p o r t a n c e and t h e a s s e t s i n c l u d e d and t h e method o f t h e i r e v a l u a t i o n w i l l n o t d e s t r o y t h e e f f e c t i v e use o f t h e r a t i o s so l o n g as t h e y a r e d e t e r m i n e d on t h e same b a s i s y e a r a f t e r y e a r and f o r a l l measurement purposes.^ Many w o u l d n o t agree w i t h t h i s s t a t e m e n t and w o u l d i n s i s t on a c e r t a i n v a l u a t i o n o f a s s e t s .  But f o r a g e n e r a l  i n t e r - c o m p a n y c o m p a r i s o n t h i s s t a t e m e n t may be t r u e . Factors outside managerial c o n t r o l .  Any e v a l u a t i o n  of m a n a g e r i a l p e r f o r m a n c e must d i s c o u n t " f a c t o r s 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 o f a company o r a  d i v i s i o n w i l l be caused by a c o m b i n a t i o n o f 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 s y s t e m o f measurement r e f l e c t both.  will  I n o r d e r t o e v a l u a t e p e r f o r m a n c e o f manage-  ment, a s s u m p t i o n s must be made about t h e e x t e n t t o w h i c h I . Wayne K e l l e r , "The R e t u r n on C a p i t a l C o n c e p t , " 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 t h e 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 m e n t i o n e d ,  b u s i n e s s c o n d i t i o n s a r e the most i m p o r t a n t . p e r f o r m a n c e t h e u n c o n t r o l l a b l e f a c t o r s may  In  divisional  o r i g i n a t e i n top  management p o l i c i e s o r a c t i o n s i n o t h e r d i v i s i o n s . o f t h e p r o b l e m i s how  general  The  crux  t o s e p a r a t e the i n f l u e n c e o f f a c t o r s  w h i c h a r e beyond the c o n t r o l o f any r e s p o n s i b l e  individual.  A l t h o u g h 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 t o s e p a r a t e d e l i b e r a t e l y o r o t h e r w i s e t h e 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 a s p e c t s o f p e r f o r m a n c e i f any v a l i d e v a l u a t i o n i s t o be made o f t h e p e r s o n s i n v o l v e d . . 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  in conflict.  s h o r t - r u n o b j e c t i v e s "may  be  o f s h o r t - r u n p r o f i t s may  be a t odds w i t h the l o n g - r u n o b j e c t -  i v e s o f s u r v i v a l and g r o w t h .  The  and  maximization  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 t a k e n t o improve c u r r e n t p e r f o r m a n c e of. a o r a company and  division  a c t i o n s w h i c h a r e aimed a t i m p r o v i n g  run p r o f i t a b i l i t y .  R e s e a r c h o r m a i n t e n a n c e a r e good examples.  Postponment o f 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 p e r f o r m a n c e b u t , as a r u l e , a t t h e expense o f long-run operations II  long-  and  the  a b i l i t y t o compete.  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  w h i c h t h e r a t e of r e t u r n on i n v e s t m e n t w i l l i d e a l l y measure  25 m a n a g e r i a l , p e r f o r m a n c e . What i s r e q u i r e d i s t h e measure o f achievement o f company's g o a l s . T h i s i s made v e r y complex by t h e f a c t t h a t b u s i n e s s e s 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 w h i c h o v e r l a p and t o some degree c o n f l i c t : p r o f i t s , s o c i a l , a c c e p t a n c e , employee s a t i s f a c t i o n , development Of new order-,., g r o w t h , market s h a r e , and e t e r n a l l i f e . Because o f our f r e e e n t e r p r i s e s y s t e m and o b l i g a t i o n s t o i n v e s t o r s , p r o f i t s a r e u s u a l l y t h e dominant g o a l o f business a c t i v i t y . They can u s u a l l y be measured w i t h r e a s o n a b l e a c c u r a c y ; 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 f o r m . The o t h e r 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 t o l o n g - r u n p r o f i t s and t h u s eannot.be i g n o r e d i n m e a s u r i n g and e v a l u a t i n g m a n a g e r i a l p e r f o r m a n c e . The m a i n p e r f o r m a n c e o f e x e c u t i v e s , however, r e m a i n s 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 t o company p a s t , p r e s e n t , and f u t u r e profits. The  a t t e m p t was  made t o p r e s e n t c e r t a i n c o n d i t i o n s  where t h e r a t e o f r e t u r n on i n v e s t m e n t can r e f l e c t p e r f o r m a n c e o f management most e f f e c t i v e l y . e r a t i o n s may t o use and  operating  These c o n s i d -  be u s e f u l t o d e c e n t r a l i z e d companies d e s i r i n g  t h e r e t u r n on i n v e s t m e n t as a method o f m e a s u r i n g  evaluating executive Company l e v e l .  performance. E v e r y economic f a c i l i t y employed  by t h e e n t e r p r i s e s h o u l d be c a r e f u l l y a d m i n i s t e r e d t o p management w i t h a v i e w t o income;  by  t h e r e t u r n , on i n v e s t -  ment shows t h e e f f e c t i v e n e s s w i t h w h i c h the management handled the a v a i l a b l e resources  the  entrusted  to i t s care.  26 Income,however, may he due t o a c o n t r i b u t i o n o f 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  effectiveness  o f t h e r a t e o f r e t u r n on i n v e s t m e n t i n e v a l u a t i n g p e r f o r m 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 a r e separated.  2.  P e r f o r m a n c e i s measured a g a i n s t a r e a l i s t i c standard.  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 and e l i m i n a t e d .  Judgment must be employed.  identified  Standards  must-be d e t e r m i n e d i n l i n e w i t h o t h e r b u s i n e s s o b j e c t i v e s and c o m p e t i t i o n .  T h i s means t h a t t h e y a r e n o t  absolute  but r a t h e r depending on t h e b e s t p o s s i b l e achievement the e x i s t i n g  under  circumstances.  Division level.  On t h e d i v i s i o n a l , l e v e l , t h e  r e t u r n on i n v e s t m e n t w i l l e f f e c t i v e l y measure  executive  p e r f o r m a n c e i f t h e company i s d i v i d e d i n t o i n d e p e n d e n t o p e r a t i n g u n i t s w h i c h a c t l i k e economic e n t i t i e s f r e e t o t r a d e i n s i d e a n d . o u t s i d e t h e company.  P r o p e l l e d by  appropriate  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 t o maximize i t s own c o n t r i b u t i o n t o g e n e r a l o v e r h e a d and p r o f i t s w h i c h w i l l a l s o maximize t h e p r o f i t s o f t h e e n t i r e company. c o n f l i c t s may  Certain  a r i s e f r o m t h e d i v i s i o n ' s a t t e m p t .to maximize  i t s own p r o f i t s .  T h i s p r o b l e m w i l l be d e v e l o p e d i n  further discussion. D i v i s i o n a l manager c a n be made r e s p o n s i b l e f o r t h e p e r f o r m a n c e o f 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  c a n "be e v a l u a t e d  i n terras o f the r a t e o f r e t u r n on  i f the f o l l o w i n g c o n d i t i o n s a r e  investment  fulfilled:  1.  The d i v i s i o n a l b o u n d a r i e s a r e marked o f f so as t o p r e s e r v e 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 , r e v e n u e , 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 o f a l l o c a t i o n u s e d .  2.  Intra-company p r i c e s a r e 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 a c c e s s t o d a t a on a l t e r n a t i v e s o u r c e s and m a r k e t s and freedom t o d e a l w i t h o u t s i d e r s .  3.  Divisional  c o n t r i b u t i o n p r o f i t s a r e measured  correctly,  i . e . , p r o f i t s o v e r w h i c h the  i o n a l manager has 4.  divis-  control.  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 p e r f o r m a n c e are d e t e r m i n e d by r e v i e w o f p a s t r e c o r d and c l i m a t e and  consideration of.current competitive  economic  c o n d i t i o n s i n the  industry. 5.  P r o p e r i n c e n t i v e s a r e e s t a b l i s h e d and r e l a t e d t o t h e c o n t r i b u t i o n p r o f i t s o f the  6.  division.  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 t o p management.  28  7.  The d i v i s i o n manager i s n o t 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 i s permitted  he t o o k o v e r , u n l e s s he  to r e v i s e the previous  decision.  R e f e r r i n g t o 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 t o s a y : 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 i n v e s t m e n t p r o v i d e s t h e most i m p o r t a n t g u i d e t o t o p management i n e v a l u a t i n g o f p r o f i t center performance.^ Dean's comment i s t r u e , b u t o n l y i f most o f t h e 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 a r e w i l l i n g ' o r a b l e t o go t h e l e n g t h s u g g e s t e d h e r e . The p r i c e a s k e d f o r o b j e c t i v i t y may be t o o h i g h .  1  J o e l Dean, " P r o f i t Measurement o f 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 b e s t way t o c a l c u l a t e the r a t e o f r e t u r n f o r a d i v i s i o n o r a eompany. B o t h the i n v e s t m e n t 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 o f income i s c l o s e l y r e l a t e d t o the p r o b l e m o f v a l u a t i o n o f t h e i n v e s t m e n t base and t h e d e f i n i t i o n of must be c o n s i s t e n t w i t h t h e d e f i n i t i o n o f t h e o t h e r .  one  Most o f t h e d i s c u s s i o n i n the l i t e r a t u r e on t h e a l t e r n a t i v e methods has been c o n c e r n e d w i t h f i n d i n g an a c c u r a t e r a t e o f r e t u r n — o r perhaps even some k i n d o f " t r u e " r a t e o f r e t u r n . L i t t l e has been s a i d about the use o f r a t e of r e t u r n on i n v e s t m e n t 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 t o p management p e r f o r m a n c e . General background. t o use ing  an a c c o u n t i n g  The  management i s not  bound  c o n c e p t o f income i n g u i d i n g and  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  evaluat to  the p r e s e n t t i m e , however, no b e t t e r p r a c t i c a l ways o f c o m p u t i n g income have been advanced t h a n t h o s e d e v e l o p e d by the a c c o u n t i n g  profession.  the best accounting  I t i s suggested then that  c o n c e p t o f income, w i t h p r o p e r m o d i f i c -  a t i o n s , be u s e d I n t h e r a t e o f r e t u r n a n a l y s i s . B e f o r e a c c e p t i n g t h e a c c o u n t a n t ' s c o n c e p t o f 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 inherent  i n the income c o n c e p t and beware o f  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 . In g e n e r a l , the accounting concept of business income i s an excess o f r e v e n u e s o v e r c o s t s i n c u r r e d i n producing- t h e r e v e n u e s . P a t o n and L i t t l e t o n s a y t h a t , "Cost i s t h e amount o f b a r g a i n e d - p r i c e o f goods o r s e r v i c e s r e c e i v e d o r o f 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 . " ^ " B a r g a i n e d - p r i c e " i s s i m p l y a u n i t p r i c e times q u a n t i t y . "Revenue," a c c o r d i n g t o P a t o n and L i t t l e t o n , " i s t h e p r o d u c t o f t h e e n t e r p r i s e , measured by the amount o f new a s s e t s r e c e i v e d f r o m c u s t o m e r s ; income emerges when t h e a s s e t s w h i c h e x p r e s s revenue exceed the t o t a l of assignable costs."2 I t i s i m p l i c i t i n the concept o f business e n t i t y , a company o r a d i v i s i o n , t h a t p r o p e r t y d e d i c a t e d t o b u s iness purposes belongs t o 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 . T h e r e f o r e , i t s h o u l d be a c c o u n t e d f o r s e p a r a t e l y f r o m t h e p r o p e r t y o f t h e i n v e s t o r s who a r e , however, e n t i t l e d t o s h a r e i n t h e income p r o d u c e d by t h e 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 t h e a d m i n i s t r a t i o n o f a l l t h e 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 handling the a v a i l a b l e r e s o u r c e s 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 t h e purpose o f accounting-, 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  P a t o n and  that:  W.A. P a t o n and A.C. L i t t l e o n , An I n t r o d u c t i o n t o 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 a s a means o f c o m p u t i n g a r e s i d i u m , a b a l a n c e , t h e d i f f e r e n c e between c o s t s (as e f f o r t s ) , a n d r e v e n u e s ( a s a c c o m p l i s h m e n t s ) 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 manage r i a l e f f e c t i v e n e s s and i s o f p a r t i c u l a r s i g n i f i c a n c e t o t h o s e who f u r n i s h t h e c a p i t a l a n d t a k e t h e u l t i m a t e responsibility.^  In  evaluating managerial  figure  i s very  improtant.  income  i s a complex p r o b l e m  performance,  t h e income  But the determination o f business i n accounting.  t i o n s may r e q u i r e a d e p a r t u r e  from  Differing  the accepted  situa-  standards  and  conventions. The on  " t r u e " income f i g u r e  the d i s s o l u t i o n of a business  c a n o n l y be a r r i v e d a t or completion  C o m p u t a t i o n o f income f i g u r e  i n case  adventurer  simple.  of  was c o m p a r a t i v e l y  a series  was s i m p l y venture  of isolated ventures, the difference  beginning  and a f t e r  was c o m p l e t e l y was e a s i l y  It entities of  such  of a medieval  and t h e income o n e a c h sunk i n each  on i t s completion.  t h e end o f each v e n t u r e ,  "liquid"  merchant  His business consisted  between t h e c a p i t a l  a n d t h e sum r e a l i z e d  of a venture.  Before the  t h e merchant  and so t h e growth i n h i s c a p i t a l  measured.  i s when b u s i n e s s  e n t e r p r i s e s become  t h a t i t becomes d i f f i c u l t an e n t e r p r i s e t o p a r t i c u l a r 1  Ibid.,  p . 16.  to attribute  continuous t h e income  short periods o f time,  32 s u c h as a y e a r . P o r i f income o f t h e 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 r e g a r d e d as b e i n g t h e g r o w t h i n i t s c a p i t a l d u r i n g t h e 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 o r amounts w i t h d r a w n ) , a v a l u e s h o u l d be p l a c e d on t h e e n t e r p r i s e a t t h e b e g i n i i i n g and end o f t h e p e r i o d , i n o r d e r to'measure t h i s g r o w t h . 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 o f goods, i n v e s t m e n t s , equipment, l a n d and b u i l d i n g s , and s u c h i n t a n g i b l e " r i g h t s " as p a t e n t s and c o p y r i g h t s o r a t l e a s t some o f t h e s e a s s e t s j as w e l l as a s s e t s l i k e c a s h and book d e b t s w i t h a known f a c e v a l u e , t h e p r o b l e m o f v a l u a t i o n becomes v e r y d i f f i c u l t . The p r o b l e m  i s t o some e x t e n t s o l v e d by t h e  d u c t i o n o f t h e concept fundamental  problem,  o f m a t c h i n g r e v e n u e s and c o s t s .  The  on t h i s v i e w , i s t o d i s t i n q u i s h between  ( a ) t h o s e e x p e n d i t u r e s w h i c h s h o u l d be charged c u r r e n t revenue and  intro-  against  (b) t h o s e e x p e n d i t u r e s w h i c h s h o u l d  be  c a r r i e d f o r w a r d t o be c h a r g e d a g a i n s t t h e revenue o f f u t u r e periods.  These l a t t e r e x p e n d i t u r e s w i l l , u n t i l t h e y a r e  charged to revenue,  be c a r r i e d i n t h e b a l a n c e s h e e t ,  but  w h e t h e r t h e y a p p e a r t h e r e d e s c r i b e d as " p l a n t " o r " s t o c k " or  " p r e l i m i n a r y expenses" o r otherwise they are  v i e w e d as p a s t e x p e n d i t u r e s h e l d i n  suspense.  I t i s u s u a l l y c l a i m e d f o r t h e "matching revenue"  approach  always  c o s t s and  t o 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 a v o i d s v a l u a t i o n s as f a r as p o s s i b l e , substitutes cost a l l o c a t i o n s .  and  I t i s t h e b e s t method o f  33 income  d e t e r m i n a t i o n d e v i s e d thus  however, r e v e a l s c e r t a i n  Consider, n e e d t o he say  the  s e v e r a l years, or the lots  at d i f f e r e n t  three years.  typical  b e t w e e n two  cost of c e r t a i n  items  in  prices,  and  sold  Is t h e r e r e a l l y ,  period  second  c a s e , what  i f sale  been purchased  lots  prices is  out  are changing  perhaps  more f a m i l i a r  outlays  of the problem are not  the y e a r ' s  straight-line,  will  methods a r e figure.  price,  time.  The  The  as  first  different  only i n c i d e n t a l l y  "first-in,  commonly"used,  each  or one  to  as  i s simply  goods  while  of these  of  one  having  identical  that  problems the  computing  another whatever  s t o c k s must be  charged  in  d e p r e c i a t i o n charge, o t h e r methods a r e i n a l l cases  coincide with  income..  of  i n any  calculating  second,  and  for  of saying,  continually  a problem.of  forward  be  any  identified because  business  reducing balance,  first-out,"  be  In c a l c u l a t i n g  pended to e a r n p e r i o d i c "last-in,  Or  of s t o c k v a l u a t i o n because  income f i g u r e w i l l  charge  case,  c o s t of goods s o l d  d u r i n g the y e a r  carried  accounts.  as  last  a p e r i o d o f two  i t s services?  assets.  c o s t o f goods s o l d  aspect  The  of the  periods—  c o s t s of the p l a n t  actually  a l l the  depreciation of f i x e d the  the  i s the  cannot  over  which  i n a number  i n the f i r s t  at a p a r t i c u l a r  a r e f l o w i n g i n and  o r more t r a d i n g  c o s t o f goods bought  of the years which enjoy  the  expenditures  of p l a n t which w i l l  o b j e c t i v e method o f a l l o c a t i n g each  examination,  flaws.  f o r example,  allocated  f a r ; closer  the  and  used.  the  effort  ex-  In inventory valuation, first-out," producing  and  average  a"different  income  34  The d e t e r m i n a t i o n o f "business income i s t o a g r e a t e x t e n t s u b j e c t i v e . The a c c o u n t i n g p r o f e s s i o n has f o r a h a l f a c e n t u r y been a t t e m p t i n g i n t e r m i t t e n t l y and w i t h i n a d e q u a t e power t o improve on t h i s s u b j e c t i v e concept and a r r i v e a t o b j e c t i v e and r e a s o n a b l y n a r r o w range o f meanings. The E n g l i s h c o u r t s , w h i c h have w r e s t l e d w i t h t h e p r o b l e m o f m e a s u r i n g b u s i n e s s income o v e r a l o n g p e r i o d o f t i m e , have i n t h e language o f t h e House o f l o r d s i n Davey v.: C o r y : ... d e c l i n e d t o attempt t o t r e a t t h e s e q u e s t i o n s i n t h e a b s t r a c t o r t o do t h a t w h i c h P a r l i a m e n t has r e f r a i n e d f r o m d o i n g , namely t o f o r m u l a t e p r e c i s e r u l e s f o r t h e g u i d a n c e o r embarrassment o f b u s i n e s s men i n t h e conduct o f b u s i n e s s a f f a i r s . ^ There i s a n o t h e r p r o b l e m o f t h e f a l l a c y o f a c c o u n t i n g a s s u m p t i o n o f money b e i n g a . c o n s t a n t m e a s u r i n g r o d and t h e 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 o f 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 o f computing income a r e u s e d 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 o f d e t e r m i n i n g t h e " t r u e " income l i m i t t h e c o m p a r a b i l i t y o f income f i g u r e s between companies and divisions.  The l i m i t i n g f a c t o r s s h o u l d a l w a y s be b o r n i n  mind when e v a l u a t i n g p e r f o r m a n c e i n terms o f t h e r a t e o f r e t u r n on i n v e s t m e n t . Henry B. B u c k l e y  ( L o r d W r e n b u r y ) , The Law and  P r a c t i c e Under,the Companies A c t S t e v e n s , 1 9 3 0 ) , p. 756.  ( E l e v e n t h e d i t i o n ; London:  35  I  INCOME DEFINITIONS FOR INTER-COMPANY ' COMPARISONS •  Any d e f i n i t i o n o f income s h o u l d he c o n s i s t e n t w i t h t h e d e f i n i t i o n o f i n v e s t m e n t when the two a r e r e l a t e d i n t h e r a t e o f r e t u r n on i n v e s t m e n t . G e n e r a l l y , income s h o u l d he d e f i n e d as a l l income a r i s i n g out o f the use o f t h e a s s e t s f o r w h i c h t h e management . i s h e l d r e s p o n s i b l e and o v e r w h i c h the management, has c o n t r o l . To d e f i n e income i n any o t h e r way i s t o l i m i t i t s usefulness i n a p p r a i s i n g managerial performance. T h i s means t h a t income, f o r the p u r p o s e s o f r e t u r n o f i n v e s t m e n t measurement i n a p p r a i s i n g - p e r f o r m a n c e , i s the net i n c o m e . f i g u r e produce i t .  The  a f t e r a l l c o s t s and  net income f i g u r e , s h o u l d i n c l u d e  income and n o n - r e c u r r i n g control.  expenses r e q u i r e d t o operating-  i t e m s o v e r w h i c h management  has  I n p r a c t i c e . , t h i s a l l - i n c l u s i v e c o n c e p t of income  i s - t h e b e s t , because e x p e r i e n c e  shows t h a t most o f non-  r e c u r r i n g i t e m s o f income o r o r d i n a r y . l o s s e s a r e under m a n a g e r i a l c o n t r o l and a c t u a l l y do r e c u r , and because l i n e o f d e m a r c a t i o n between o p e r a t i n g i t e m s and o p e r a t i n g i t e m s i s not c l e a r - c u t and opinion.  the  non-  i s o f t e n a matter of  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  management cannot be h e l d r e s p o n s i b l e s h o u l d be  the excluded.  ...In..the p u b l i s h e d l i t e r a t u r e , t h e p r i n c i p a l q u e s t i o n s w h i c h a r i s e i n d e f i n i n g income c e n t e r around the f o l l o w i n g  36 three categories of items: 1.  D i v i d e n d 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 " o t h e r expense."  3.  D e p r e c i a t i o n expense.  These i t e m s a r e examined i n t h e f o l l o w i n g p a r a graphs i n terms o f t h e 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 - o t h e r income. Where d i v i d e n d s and i n t e r e s t a r e i t e m s o f income, most companies i n c l u d e t h e s e i t e m s i n e a r n i n g s f o r t h e . p u r p o s e o f m e a s u r i n g r e t u r n on i n v e s t m e n t . "Other income," f o r example g a i n s on s a l e o f 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, e x c l u d e Mother income" on t h e grounds t h a t i t e m s f a l l i n g i n t o t h i s c a t e g o r y a r e . o f t e n n o n - r e c u r r i n g , s u c h as s a l e s o f m a j o r a s s e t s , and, c o n s e q u e n t l y , have n o t h i n g t o do w i t h e a r n i n g power. S i n c e 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 utilization  o f a l l company a s s e t s , t h e t h r e e " c a t e g o r i e s  o f income s h o u l d be i n c l u d e d i n n e t income i n c o m p u t i n g the r a t e , o f r e t u r n . o n i n v e s t m e n t , p r o v i d e d t h e management has the r e q u i s i t e c o n t r o l t o cause t h e income t o emerge.  In  e v a l u a t i n g m a n a g e r i a l p e r f o r m a n c e a l l income, o p e r a t i n g and non-operating,  s h o u l d be merged i n t o one t o t a l f i g u r e .  t h e f i n a l a n a l y s i s , t h e r e i s no d i f f e r e n c e between  In  income,  37  as e x p r e s s e d i n money t e r m s , w h i c h a r i s e s f r o m o r d i n a r y o p e r a t i o n s and d i v i d e n d o r o t h e r income; a l l r e p r e s e n t good money. T h i s i s n o t t o s a y 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 n o t d e s i r a b l e ; on t h e c o n t r a r y , - i n a n a l y s i n g t h e r a t e , o f r e t u r n on i n v e s t m e n t i t i s i m p e r a t i v e t h a t v a r i o u s k i n d s o f 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 t h e u n d e r l y i n g i n v e s t m e n t t o see how t h e t o t a l r e s u l t i s made up and to make t h e n e c e s s a r y 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 r e s o u r c e s and i t i s up t o i t s i n g e n u i t y and f o r e s i g h t t o 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 t a x e s , and o t h e r expense. S i n c e t h e . r a t e o f r e t u r n on i n v e s t m e n t i s u s e d t o measure p e r f o r m a n c e o f management, i . e . , e f f e c t i v e n e s s o f u t i l i z a t i o n o f r e s o u r c e s , i n t e r e s t on debt s h o u l d be e x c l u d e d f r o m expenses. Some c o n c e r n s w i l l borrow a l a r g e r p o r t i o n o f t h e i r c a p i t a l requirments  t h a n o t h e r s 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  f r o m t i m e t o t i m e and o t h e r s a v o i d t h e n e c e s s i t y o f 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 o f where  they  come f r o m . I n t h e words o f P a t o n and L i t t l e t o n : Prom"the p o i n t o f v i e w o f t h e e n t e r p r i s e as a n economic e n t i t y and a c e n t e r o f m a n a g e r i a l a c t i v i t y ,  38 on t h e o t h e r hand, t r e a t m e n t o f i n t e r e s t as a charge a n a l o g o u s t o o p e r a t i n g c o s t s s u c h as l a b o r and m a t e r i a l s i s o b j e c t i o n a b l e . To management"the c o s t of o p e r a t i n g the u n d e r t a k i n g i s not a f f e c t e d by t h e f o r m o f c a p i t a l s t r u c t u r e employed, n o r by t h e p a r t i c u l a r k i n d s of i n s t r u m e n t s used i n r a i s i n g the n e c e s s a r y funds. To management the b o n d h o l d e r s d o l l a r s and t h e money f u r n i s h e d by t h e s t o c k h o l d e r s become amalgamated i n t h e body o f r e s o u r c e s 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 o f the e n t e r p r i s e c o n s i s t s o f t h e e n t i r e amount a v a i l a b l e f o r a p p o r t i o n m e n t 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 c h a r g e s , f r o m t h i s s t a n d p o i n t , a r e not o p e r a t i n g c o s t s but r e p r e s e n t a d i s t r i b u t i o n o f income, somewhat a k i n t o dividends... 1  The p o i n t t o be n o t e d 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 w h i c h a company i s f i n a n c e d , w h i l e t h e income f r o m 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 o f 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 * i n v e s t m e n t . It is for financial management t o d e t e r m i n e t h a t s a t i s f a c t o r y income.earned i n the conduct o f a b u s i n e s s i s r e a l i z e d by the s t o c k h o l d e r s t o the f u l l e s t e x t e n t i n t h e f o r m o f s u r p l u s net income. The  net income f i g u r e u s e d f o r i n t e r - c o m p a n y  c o m p a r i s o n s i s u s u a l l y income a f t e r t a x e s ; e r e d t o be a c o s t w h i c h must be c o v e r e d a r e t u r n on i n v e s t m e n t .  taxes are  consid-  before there can  be  What i s wanted, however, i s t h e  r e t u r n on i n v e s t m e n t o v e r w h i c h management has  c o n t r o l and  no management has any c o n t r o l o v e r t a x r a t e s .  On t h i s v i e w ,  i t seems l o g i c a l t o use net income b e f o r e t a x e s .  In addition,  c o m p a r a b i l i t y o f income f i g u r e s o v e r t i m e i s not a f f e c t e d by 1 W.A. P a t o n 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 t o C o r p o r a t e A c c o u n t i n g .Standards ( A m e r i c a n A c c o u n t i n g A s s o c i a t i o n Monograph Wo. 3, 1 9 5 7 ) , pp. 43-44.  39  changing tax 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  income f i g u r e a f t e r t a x e s can he made. computes t h e net  The  income f i g u r e b o t h b e f o r e  net  Monsanto Company and  a f t e r taxes:  •Net i n c o m e , as u s e d i n t h e c a l c u l a t i o n , i s t h e net-income a f t e r a l l c o s t s and e x p e n s e s . The percentage of r e t u r n on i n v e s t m e n t b a s e d on net income a f t e r t a x e s 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 d e t e r m i n e the r e t u r n o f net income b e f o r e t a x e s i n o r d e r t o make c o m p a r i s o n s w h i c h e l i m i n a t e the e f f e c t o f changes i n t a x r a t e s . 1  As w i t h " o t h e r  income" d i s c u s s e d  above, most  companies t a k e i n t o a c c o u n t " o t h e r 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 i n v e s t m e n t . U s i n g the c r i t e r i a . o f r e s p o n s 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 , s h o u l d . b e i n c l u d e d i n the c o m p u t a t i o n o f t h e net income f i g u r e . Depreciation be  expense.  included i n operating  Depreciation should  expenses.  o p t i o n a l charge t o be r e c o g n i z e d  Depreciation  always  i s not  an  o r not as management p l e a s e s .  O b s o l e s c e n c e i s an i m p o r t a n t f a c t o r i n d e p r e c i a t i o n o f 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 ;  assets.  i t should  be a c h a r g e t o income i r r e s p e c t i v e o f whether income  has  been e a r n e d o r n o t , whether income can o r cannot " s t a n d charge."  The  r e a l amount o f income i s d e t e r m i n e d by  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  by the management's p o l i c y w i t h r e s p e c t  to  the  operaffected  depreciation.  40 Conclusion.  The  enterprise resources reflected  i n the  income,  the  Therefore,  he  net  inter-company  charges f o r  on  as  the  other  operating  of  practice, This  i n t e r e s t and  activity  conditions.  a systematic history  the  form of  this  income  i n the  element  its real  enterprise  capital  operating  paper,  that  an  tries  rate  of  the be  depends  on  probable  adopted. being  In  followed.  evaluating investment.  operating  employed  does not  i t i s the  of r e t u r n  t o measure and  costs  amount  of r e t u r n measure;  e n t e r p r i s e ; and  the  hut  excluded from the  income t h a n an  structure  including  depreciation^ charge,  should  be  figure  and.accompanying  on  of r e t u r n  should rate  income  taxes.  i s an  assets,  rate  from  i n i t s production,  policy,.based  i n t e r e s t charge  effectiveness in  the  a d i s t r i b u t i o n of  of  net  b o r n i n m i n d when c o m p a r i n g and  i n terms of  of  dividend  expenses  c a l c u l a t i n g the  depreciable  income f i g u r e u s e d  cost  the  d i f f e r e n t d e p r e c i a t i o n methods a r e  An  The  In  an  include  and  expense;  of  depreciation  must be  companies  like  incurred  operating  use  he  income.  comparisons,  charge f o r d e p r e c i a t i o n  any  economic  other  calculated a f t e r a l l costs  A just  management s h o u l d  income f i g u r e s h o u l d  d e p r e c i a t i o n , .whieh a r e before  hy  i n a d d i t i o n to.income  i n t e r e s t i n c o m e , and  Por should  utilized  income f i g u r e e m e r g i n g f r o m t h e  those resources. operations,  are  e f f e c t i v e n e s s w i t h which a l l the  on  i t i s more  expense. affect  the  operating  investment,  evaluate.  net  as  used  41  In  computing t h e r a t e o f 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 , t h e i n t e r e s t expense s h o u l d be d e d u c t e d f r o m income; i n t h i s c a s e , income a p p l i c a b l e t o t h e s h a r e h o l d e r s ' e q u i t y i s t h e r e s i d u a l amount a f t e r t h e payment o f i n t e r e s t . Income t a x e s a r e o u t s i d e t h e c o n t r o l o f management. The company's s u c c e s s o r l a c k o f s u c c e s s i n m i n i m i z i n g i t s income t a x e s does n o t 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 . M o r e o v e r , f r e q u e n t changes i n t a x r a t e s make c o m p a r i s o n s o v e r time d i f f i c u l t . Por these reasons the computation o f net income f o r t h e purpose o f e v a l u a t i n g company p e r f o r m a n c e i n terms o f t h e r a t e o f r e t u r n on i n v e s t m e n t seems t o be b e s t b e f o r e income t a x e s . Where t h e r a t e o f r e t u r n i s b a s e d o n s h a r e h o l d e r ' s e q u i t y , income t a x e s a r e u s u a l l y d e d u c t e d because what i s l e f t t o t h e s h a r e h o l d e r s i s income a f t e r t a x e s . II  DEFINITIONS OF INCOME- FOR  INTRA-GOMPANY  COMPARISONS. J o e l Dean s u g g e s t s  three concepts  o f income, o r  p r o f i t as u s e d by h i m , t h a t may be used i n m e a s u r i n g d i v i s i o n a l performance: a.  Book n e t p r o f i t s  b.  Real net p r o f i t s  c.  Contribution profits  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 a r e n o t v e r y f u d g i b l e , b u t t h e y 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 o f c o r p o r a t e overheads o v e r w h i c h t h e y have no c o n t r o l and r a i s e moot q u e s t i o n s about c a p i t a l c o n s u m p t i o n c o s t s of p l a n t a c q u i s i t i o n s a t w i d e l y differing price levels. R e a l n e t p r o f i t s may s e t t l e t h e l a t t e r q u e s t i o n s ( i n f l a t i o n and d e p r e c i a t i o n ) but do n o t s e t t l e problems o f a l l o c a t i o n o f overhead beyond t h e d i v i s i o n manager's control. C o n t r i b u t i o n p r o f i t s have f e w e r o f t h e s e drawbacks b e i n g c o n f i n e d t o c o s t s and revenues o v e r w h i c h t h e p r o f i t c e n t e r manager has c o n t r o l . ^ Because t h e purpose o f the r a t e o f r e t u r n on i n v e s t m e n t i s t o measure, g u i d e , and e v a l u a t e m a n a g e r i a l p e r f o r m a n c e , t h e assignment o f r e s p o n s i b i l i t y f o r p e r f o r m ance must be c o e x t e n s i v e 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 o v e r c e n t r a l l y a l l o c a t e d o v e r h e a d s , s u c h as the r e m u n e r a t i o n o f t o p e x e c u t i v e s o r t h e expenses o f t h e head o f f i c e . W h i l e r e c o v e r y o f company overheads i s i m p o r t a n t t o t o p management, i t w i l l n o t be e n s u r e d by a l l o c a t i n g them t o d i v i s i o n a l p r o f i t and l o s s s t a t e m e n t s . On t h e 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 o f d i v i s i o n a l p e r f o r m a n c e , because c o s t s a r e a t t r i b u t e d t o t h e d i v i s i o n s o v e r w h i c h 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 a r e o f no v a l u e 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 a r e a s n e e d i n g a t t e n t i o n . M o r e o v e r , a r b i t r a r i n e s s o f most a l l o c a t i n g systems i m p a i r s t h e v a l i d i t y o f any e v a l u a t i o n o f p a s t and p r e s e n t p e r f o r m a n c e , s i n c e good and bad y e a r s 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 o f 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  In decentralized operations,  however,  the d i v i s i o n  manager has c o n t r o l o v e r c o s t s and r e v e n u e s 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 a r e u s u a l l y o p e r a t i n g c o s t s and o p e r a t i n g revenue. P o r t h e s e r e a s o n s c o n t r i b u t i o n income, i . e . , t h e income w h i c h emerges out o f m a t c h i n g . o f c o s t s and r e v e n u e s o v e r w h i c h t h e d i v i s i o n manager has c o n t r o l , seems t o he the most a p p r o p r i a t e measure o f d i v i s i o n a l management. The r a t e o f r e t u r n on i n v e s t m e n t , when u s e d as an i n t e r n a l m a n a g e r i a l t o o l , need n o t he t h e same as t h a t used f o r e x t e r n a l c o m p a r i s o n s 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 a v o i d s 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 o f t h e a l l o c a t i o n o f 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 r e a s o n why i t s h o u l d be u s e d i n e v a l u a t i n g d i v i s i o n a l p e r f o r m a n c e i n terms o f t h e r a t e o f r e t u r n on i n v e s t m e n t .  44 CHAPTER V I PROBLEMS OP INVESTMENT DEFINITION I  DEFINING INVESTMENT FOR INTER-COMPANY I n p r a c t i c e , the investment  COMPARISONS  base upon w h i c h r a t e  o f 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 o f r e t u r n are used f o r d i f f e r e n t  p u r p o s e s . . I n a p p r a i s i n g p a s t r e s u l t s o f t h e company as a w h o l e , 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 assets  a p p e a r i n g on t h e l e f t hand s i d e o f t h e c o n v e n t i o n a l balance 2.  sheet.  T o t a l a s s e t s employed, i . e . , t o t a l a s s e t s  avail-  a b l e minus excess o r i d l e a s s e t s and o t h e r a s s e t s on w h i c h management i s n o t e x p e c t e d  t o earn a r e t u r n .  To p u t i t i n a n o t h e r way, t h e s e a r e earnings a s s e t s , i . e . , a s s e t v a l u e depends on who owns them as d i s t i n g u i s h e d f r o m d e f e n s i v e a s s e t s w h i c h have t h e same v a l u e no m a t t e r 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 t o common stock equity.  45 .. A l l t h e company's r e s o u r c e s a r e e n t r u s t e d t o m a n a g e r i a l c o n t r o l . To measure m a n a g e r i a l p e r f o r m a n c e t h e r e f o r e , , i t seems l o g i c a l t o use t o t a l a s s e t s a v a i l a b l e as an i n v e s t m e n t b a s e . The r a t e o f r e t u r n o n . i n v e s t m e n t computed on any .of t h e o t h e r t h r e e i n v e s t m e n t b a s e s , w i l l r e f l e c t m a n a g e r i a l 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 also consistent w i t h the d e f i n i t i o n of income as.-developed i n t h e p r e v i o u s c h a p t e r . An a d d i t i o n a l r e a s o n f o r u s i n g t o t a l a s s e t s as a n i n v e s t m e n t b a s e . i s t h a t t h e f i g u r e s a r e p u b l i c l y a v a i l a b l e a n d , t h e r e f o r e , c a n ber e a d i l y used i n inter-company comparisons. Companies w h i c h use t o t a l a s s e t s employed as t h e investment base, e l i m i n a t e t h e a s s e t s which are not expected t o e a r n a r e t u r n . Some e x c l u d e c a s h ; o t h e r s e x c l u d e c o n s t r u c t i o n i n progress o r other assets, which a r e h e l d w i t h a view to.other o b j e c t i v e s than the s h o r t - r u n maximization o f profits. . 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 s h o u l d be e a r n i n g assets.  This i s not always p o s s i b l e ,  Certain.investments,  f o r example c o n s t r u c t i o n i n p r o g r e s s , do n o t b r i n g any i n come u n t i l t h e b e g i n n i n g o f o p e r a t i o n s . sive assets should r e s u l t . i n managerial  However,,all  the long-run p r o f i t s ,  defen-  otherwise  d e c i s i o n s t o a c q u i r e and h o l d s u c h a s s e t s make  l i t t l e sense.  Since managerial  i n income a r i s i n g  effectiveness i s reflected  o u t o f a l l t h e e n t e r p r i s e a s s e t s , t h e use  o f 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 t h a n t o t a l a s s e t s employed seems t o be a b e t t e r i n v e s t m e n t  base f o r t h e p u r p o s e o f  46 company and defensive  managerial evaluation.  assets  available; r e t u r n on ing  the  the  may  lower the  effect  of  overall  company  to  This it  i n nature,  e a r n . a r e t u r n on i s very  assets  difficult  purchased with  money was  donated  assets.  The where t h e  and  i s of  takes is  the  evaluate  position  of  and  be  expected  short-term In the  as  liabilities creditors.  first  place,  to  extricate  long-term funds;  secondly,  for effective.utilization  of  money t o p u r c h a s e . t h e m o r in their  acquisition,  shareholders'  capital  interest  shareholder's  a d o p t e d where the  holders  not  debt  even  such  equity  assets as  i s used  i s to measure r a t e o f r e t u r n earned on  considerable  the  apprais  sometimes i m p o s s i b l e  short  amount.of s h a r e h o l d e r s • It  f o r when  that, since current  o f r e t u r n on  purpose  allowed  a sound argument.  expended  rate  of  s u p p l i e d by  matter.who s u p p l i e d the  when no  assets  the r a t e  management s h o u l d  management i s r e s p o n s i b l e no  total  on  equity plus.long-term  assets  is,however, not  of  performance.  t h e i r .investment base r e a s o n temporary  assets  h o w e v e r , he  Companies t h a t u s e are  existence  r a t e o f r e t u r n on  defensive  i n v e s t m e n t may,  The  employed  management  business.  t o f i n a n c i a l management  or outside  capital  i n the  stock  investor's viewpoint. is closely  i n terms of  the  h e l d and  its ability  to  and It shareimprove  shareholders.  In discussing a d e f i n i t i o n  of  investment  i n the  rate  47 of r e t u r n on investment 35 s a y s  formula,  t h e N.A.A. R e s e a r c h  R port e  that:  Some c o m p a n i e s i n t e r v i e w e d were f o u n d t o he u s i n g more t h a n one i n v e s t m e n t b a s e . These companies u s e r a t e o f r e t u r n f o r more t h a n o n e . p u r p o s e a n d 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 t h e 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 t o t h e i n t e n d e d p u r p o s e s . O t h e r companies u s e a v a r i e t y o f investment bases on o c c a s s i o n , b u t one b a s i s a s a r e g u l a r , a n d m a j o r 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 a n d c o m p e t i t o r s , t h e y sometimes r e v i s e t h e i r investment base t o conform w i t h t h e 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  In capital, key  i n t e r n a l p e r f o r m a n c e measurement  i . e . , management, r a t h e r  figure.  than the s u p p l i e r  T o t a l a v a i l a b l e assets  ment's d i s p o s a l ; best"investment  total  assets,  b a s e t o be u s e d  the user of  are placed  therefore,  i s the  a t manage-  seem t o be t h e  i n managerial  performance  appraisal.  I n some c a s e s , trade  certain,resources,  marks, and l e a s e d  sheet.  I n other  cases,  assets,  on i n t a n g i b l e a s s e t s ,  etc.  The e x i s t e n c e  in  a higher  rate  of  such a s s e t s .  inter-company  a r e omitted from  i ti s difficult  value  goodwill,  o f such assets  of return This  s u c h as  patents,  the balance  to p u t an o b j e c t i v e  patents,  trade  marks,  i s generally reflected  t h a n i t w o u l d be i n t h e a b s e n c e  should  be c o n s i d e r e d  i n comparing  performance.  1 (NiA.A.  R e t u r n on Capital.' as a Guide t o M a n a g e r i a l R e s e a r c h R e p o r t 35, 1959), p.9.  Decisions  48  L e a s e d a s s e t s do n o t u s u a l l y appear on t h e b a l a n c e s h e e t . When s u c h . a s s e t s have a m a t e r i a l . e f f e c t on income, t h e y s h o u l d be i n c l u d e d i n i n v e s t m e n t b a s e , o t h e r w i s e t h e r a t e s o f r e t u r n on i n v e s t m e n t cease t o be .comparable. Often, l e a s e arrangements r e p r e s e n t a f o r m o f b o r r o w i n g . I n t h e s e c a s e s , 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 t h e i n v e s t m e n t b a s e . The d i f f e r e n c e between t h e t o t a l r e n t p a y a b l e and imputed i n t e r s t i s c h a r g e d as a n expense o f t h e p e r i o d . I t i s f a i r l y o b v i o u s t h a t i n b u s i n e s s e s where human resources  are the major source o f e a r n i n g s , . f o r  enterprises rendering  example i n  professional services, appraisal of  management i n terms o f t h e r a t e o f r e t u r n on i n v e s t m e n t has little  meaning. II  DEFINING THE INVESTMENT CHARGED TO DIVISIONS The  d e f i n i t i o n o f d i v i s i o n a l . i n v e s t m e n t s h o u l d be  c o n s i s t e n t w i t h t h e d e f i n i t i o n o f income.  Only the assets  f o r w h i c h 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 o v e r w h i c h 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 p e r f o r m a n c e . In a d d i t i o n , the conditions l i s t e d i n Chapter.IV concerning d i v i s i o n a l b o u n d a r i e s , t r a n s f e r p r i c i n g , e t c . , must be f u l filled. The  d i v i s i o n was d e f i n e d e a r l i e r as a u n i t t o w h i c h  both, income and i n v e s t m e n t a r e a t t r i b u t a b l e .  This  applies  l a r g e l y t o d e c e n t r a l i z e d companies o p e r a t i n g on s e m i autonomous b a s i s .  Even h e r e , t h e r e  i s a p r o b l e m o f what  49  a s s e t s t o i n c l u d e and what a s s e t s t o e x c l u d e o r how  to  a l l o c a t e f a c i l i t i e s w h i c h a r e s h a r e d i n common by two o r more d i v i s i o n s . The m a i n c r i t e r i o n s h o u l d be: has t h e d i v i s i o n a l manager c o n t r o l o v e r t h e a s s e t ? Can he, i n o t h e r words, use t h e a s s e t i n any way t o a t t a i n t h e d e s i r e d o b j e c t i v e s w i t h o u t r e s t r i c t i o n s o r c o n s t r a i n t f r o m t h e t o p management. I f s o , t h e a s s e t s h o u l d be i n c l u d e d i n t h e i n v e s t m e n t b a s e ; i f n o t , 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 , o t h e r w i s e t o p management i s e v a l u a t i n g itself. A l l o c a t i o n o f common f a c i l i t i e s on a r b i t r a r y as i s t h e c a s e i n p r a c t i c e , and i n c l u s i o n o f s u c h  basis,  facilities  i n t h e r e t u r n on i n v e s t m e n t c a l c u l a t i o n s does n o t r e f l e c t 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 . manager may  the  Although t h e . d i v i s i o n a l  be r e s p o n s i b l e f o r t h e use o f s u c h f a c i l i t i e s ,  he has no c o n t r o l o v e r them. s h o u l d be a v o i d e d .  Such a r b i t r a r y  allocations  The p r o b l e m c a n 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 t h e j u r i s d i c t i o n o f a s e p a r a t e head, or  by p l a c i n g them under t h e c o n t r o l o f a m a j o r u s e r and  e s t a b l i s h i n g , a t t h e same t i m e , sound p r i c i n g o f s e r v i c e s r e n d e r e d by t h e f a c i l i t i e s  to d i f f e r e n t  divisions.  I n many c a s e s even when f a c i l i t i e s a r e 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 c a s h a r e commonly  centralized.  Some companies i n c l u d e c a s h ; some e x c l u d e i t . Some e s t a b l i s h a c e r t a i n minimum c a s h requirements*. Whether to i n c l u d e o r e x c l u d e c a s h f r o m d i v i s i o n a l i n v e s t m e n t 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 o v e r cash.  U s u a l l y , t h e c o n t r o l o f c a s h i s i n t h e hands o f t o p  management; t h e c a s h r e s o u r c e s a r e p o o l e d . f r o m a l l o f t h e company and a d m i n i s t e r e d c e n t r a l l y .  segments  I n these circum-  s t a n c e s , c a s h s h o u l d n o t 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 . include actual figures.  Some companies  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 ; o t h e r s e x c l u d e them. When t h e d i v i s i o n manager can.change t h e terms o f s a l e and i s r e s p o n s i b l e f o r t h e c o l l e c t i o n o f a c c o u n t s r e c e i v a b l e , i n c l u s i o n o f 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 i n v e s t m e n t base makes any chages i n terms o f c o l l e c t i b i l i t y o f a c c o u n t s r e f l e c t e d i n t h e d i v i s i o n a l performance. Under t h e s e c i r c u m s t a n c e s a c c o u n t s r e c e i v a b l e s h o u l d be i n c l u d e d . However, W i l l i a m R o t c h f o u n d t h a t i n v e s t m e n t i n a c c o u n t s r e c e i v a b l e and c a s h was c o n s i d e r e d by t h e t o p management t o be a n i n f l e x i b l e p r e r e q u i s i t e o f b u s i n e s s and a p a r t o f t o p management f i n a n c i a l policy. 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 a n d . s a l e s . o f h i s d i v i s i o n , and i n v e n t o r y i s . u n d e r h i s control. sales.  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 There' a r e a number o f d i f f e r e n t ways o f v a l u i n g . .- :  i n 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 R o t c h , " R e t u r n on I n v e s t m e n t 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 , 1 9 5 8 ) , pp. 118-119.  51 last  are  first and  sold first),' "first-in,  are  disposed  when c o m p a r i n g  important rising  different the  these  prices,"first-in,  first-out"  lower of  first-out"  p r o d u c e more c u r r e n t  method.  This  (goods  In  times  method o f values  than in  .  "last-in,  comparing divisions  same m e t h o d o f used  of  inventory  companies t h a n i n comparing v a r i o u s  t o be  etc.,  divisions i t is  i s more i m p o r t a n t  i s most l i k e l y  bought  or market,  differences.  same company, w h e r e t h e  inventory  cost  d i f f e r e n t c o m p a n i e s and  to r e c o g n i z e  valuation w i l l  in  first),  first-out"  valuing  throughout  the  entire  company.  Fixed of  are  d i v i s i o n m a n a g e r and  ment b a s e . should he  assets  not  As be  stated held  u s u a l l y under should  before,  a plant  has  changed  been c l o s e d  the  d i v i s i o n manager s h o u l d  for  the  amount o f  capital  closed  down p l a n t ,  unless  revise  the  on has  investment little  The to  used  be  invested  before  order.  not  For  disposed  r e l i e v e d of r e s p o n s i b i l i t y i n the  o r . u n t i l he  assets  of  i s permitted  d e c i s i o n , otherwise i n evaluating  manager  made  i n short  down b u t  invest-  the  managerial  rate  this to  of  return  performance  meaning.  problem of gross  b o t h company and  paragraphs.  in his  for decisions  of,  previous  included  however, d i v i s i o n  responsible  t o o k . o v e r , w h i c h c a n n o t be  example,-if  be  direct control  or net  f i x e d assets  divisions i s treated  applicable  i n subsequent  52 III  ALLOCATION OF ASSETS TO DIVISIONS  The p r o b l e m o f a l l o c a t i o n o f a s s e t s t o d i v i s i o n s was t o u c h e d upon i n t h e p r e c e d i n g  s e c t i o n dealing 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  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  deals  a s s e t s and  costs 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 n o t so,much i n the t a s k o f 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 h a r d a s s i g n m e n t , as i n t h e i n a b i l i t y o f t h e d i v i s i o n manager t o c o n t r o l s u c h a s s e t b a l a n c e s .  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 i n v e s t m e n t b a s e , t h e r a t e o f r e t u r n on i n v e s t m e n t which includes such assets  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 p e r f o r m a n c e . Most o f t h e commonly u s e d a l l o c a t i o n methods c e n t r a l l y administered  c u r r e n t a s s e t s , s u c h as. c a s h ,  assign invent-  o r i e s , o r a c c o u n t s r e c e i v a b l e , on some a r b i t r a r y i n d e x o f 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 t o s a l e s o r a r a t i o t o production.  These methods, however, assume a p r o p o r t i o n -  a l i t y between a s s e t b a l a n c e s and a c t i v i t y t h a t , i n f a c t , may n o t e x i s t .  An i n 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 increase  i n inventor-  ies.  continues  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  at  the same r a t e , more t h a n p r o p o r t i o n a l a c c u m u l a t i o n o f i n ventory  b a l a n c e s may  result.  53  T h i s p r o b l e m may be solved, by c h a r g i n g t o a d i v i s i o n the a c t u a l amounts o f 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 c a n be t r a c e d t o t h a t d i v i s i o n , p r o v i d e d t h e d i v i s i o n a l manager can c o n t r o l s u c h a s s e t s . P o r example, i f inventory 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 t h e n any changes i n i n v e n t o r y l e v e l s s h o u l d be r e f l e c t ed i n the r a t e o f r e t u r n on i n v e s t m e n t . On t h e o t h e r hand, i f i n v e n t o r y l e v e l s a r e 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 s h o u l d not be r e f l e c t e d i n t h e i n v e s t m e n t base o f t h e d i v i s i o n . • Any  c e n t r a l l y administered  a s s e t s t h a t cannot  t r a c e d t o d i v i s i o n s o r a r e not s u b j e c t t o c o n t r o l by d i v i s i o n managers s h o u l d be l e f t out p f the  be the  divisional  i n v e s t m e n t base a l t o g e t h e r ; o t h e r w i s e , t h e . e v a l u a t i o n o f the d i v i s i o n managers' p e r f o r m a n c e i s a p t t o be I f a l l o c a t i o n s a r e made i n o r d e r t o r e v i e w  misleading.  historical  p r o f i t a b i l i t y o f t h e d i v i s i o n s e p a r a t e l y f r o m , the p e r f o r m a n c e o f the manager, t h e r e s u l t i n g r a t e o f r e t u r n on  investment  s h o u l d not be u s e d i n a p p r a i s i n g d i v i s i o n a l management. f a c t , two r a t e s o f r e t u r n on two s h o u l d be c a l c u l a t e d :  one  In  d i f f e r e n t investment bases  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 o t h e r f o r a p p r a i s i n g t h e 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  administered  a s s e t s t o measure the p r o f i t a b i l i t y o f the d i v i s i o n as a u n i t c a n be done a c c o r d i n g t o some budget f o r m u l a . d i s t o r t i o n o f the m a n a g e r i a l  In effect,  performance e v a l u a t i o n would  result. Oommon c o s t s w h i c h a r e i n c u r r e d t o e n a b l e a l l  no  d i v i s i o n s t o c a r r y out t h e i r o p e r a t i o n s can o n l y he on a r b i t r a r y b a s i s . i f the  These c o s t s w o u l d not be  d i v i s i o n c l o s e d down.  s u c h c o s t s has  54 allocated  d i f f e r e n t even  T h e r e f o r e , mere a l l o c a t i o n o f  no r e l e v a n c e i n a s c e r t a i n i n g the l e v e l o f  d i v i s i o n a l management p e r f o r m a n c e and  no a i d  in.determining  the r e l a t i v e p e r f o r m a n c e o f d i f f e r e n t d i v i s i o n s . c o s t s a r e , u s u a l l y , a l l o c a t e d on one  o f the two  Common  bases:  1. As a p r e d e t e r m i n e d lump sum, i f c o s t s a r e u n a f f e c t e d e i t h e r by the volume o f a c t i v i t y i n the d i v i s i o n o r 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  o f a c t i v i t y o r demand f o r s e r v i c e s P r e d e r m i n e d lump sum  i n the d i v i s i o n .  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 o f the p r e d e t e r m i n e d r a t e presumes c o n t r o l l a b i l i t y o v e r q u a n t i t i e s but none o v e r p r i c e s p e r u n i t o f Neither  quantity.  the f i r s t nor the s e c o n d seems t o 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 w h i c h a d e q u a t e l y r e f l e c t s the  degree o f 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 exert. manager has  o n l y happen i f the d i v i s i o n  c o n t r o l b o t h o v e r p r i c e s and  these conditions costs  T h i s can  quantities.  Where  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  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 t h a n use  arbitrary  allocations. IV Background.  PIXED ASSETS  Pixed assets  constitute, usually,  the  most s i g n i f i c a n t i t e m i n most companies u s i n g the r a t e o f  55  r e t u r n on i n v e s t m e n t i n e v a l u a t i n g m a n a g e r i a l p e r f o r m a n c e . F i x e d a s s e t s loom l a r g e i n t h e l i t e r a t u r e on the r a t e , o f r e t u r n on  investment.,  The  f i x e d a s s e t 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 a s s e t 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 o f o t h e r goods and s e r v i c e s ; any i t e m of p l a n t . ^ The  g r e a t e s t p r o b l e m a r i s e s . i n how  a s s e t s i n the i n v e s t m e n t b a s e , i . e . , use  to t r e a t f i x e d  of gross  fixed  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 g r o s s and n e t f i x e d , a s s e t s a r i s e s  t h e n f r o m the t r e a t m e n t o f a c c u m u l a t e d d e p r e c i a t i o n w h i c h i s d e d u c t e d f r o m the o r i g i n a l c o s t t o a r r i v e a t n e t assets.  fixed  There a r e a l s o v a l u a t i o n a c c o u n t s f o r a s s e t s  other  t h a n f i x e d , s u c h as an a l l o w a n c e f o r bad •debts', an a l l o w a n c e :  f o r i n v e n t o r y l o s s e s , e t c . , and t h e 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 o t h e r a s s e t s .  Since the other v a l u a t i o n  a c c o u n t s a r e much s m a l l e r . t h a n t h e . a c c u m u l a t e d d e p r e c i a t i o n a l l o w a n c e on f i x e d a s s e t s , t h e d i s c u s s i o n w i l l be to the h a n d l i n g of accumulated d e p r e c i a t i o n Before it  i s important  proceeding  confined  allowance.  t o d i s c u s s t h i s s u b j e c t , however,  t o c o n s i d e r what i s meant by an a s s e t  and  - - t o see what d i s t i n g u i s h e s an a s s e t f r o m an expense, s i n c e ~ (New  1  E r i e I . Kohler, A D i c t i o n a r y f o r Accountants Y o r k : P r e n t i c e - H a l l , 1953), p. 179*  W  s  56 a s s i g n m e n t o f c o s t t o one o r o t h e r c a t e g o r y 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 o f r e t u r n on investment. F i r s t o f a l l t h e r e i s no u n a n i m i t y i n p r a c t i c e as t o what i s meant by a s s e t s . f i n a n c i a l statement  The amount o f a s s e t s shown i n any  depends i n p a r t upon t h e a t t i t u d e t h a t  i s taken w i t h regard t o " c a p t i a l versus revenue" expenditures. The d i s t i n c t i o n between c a p i t a l and revenue i s f u n d a m e n t a l t o most a c c o u n t i n g p r o c e d u r e s ,  though t h e n a t u r e o f t h e d i s t -  i n c t i o n i s n o t a l w a y s made c l e a r by t h e t a x t b o o k s .  It is  often s a i d f o r instance, that c a p i t a l expenditure i s that 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 m i g h t be s a i d t h a t a n a s s e t i s what r e s u l t s f r o m c a p i t a l expenditure. d e f i n i n g an a s s e t .  T h i s b r i n g s us back t o t h e p r o b l e m o f B e s i d e s , even i f common p a r l a n c e i s a c c -  e p t e d f o r t h e moment, i t m i g h t 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 o f an a s s e t . — t w e n t y - f i v e cents spent o n a b o t t l e o f i n k , f o r i n s t a n c e . not c a p i t a l i z e d ;  B o t t l e s of i n k are  t h e y a r e w r i t t e n o f f as p a r t o f t h e c o s t o f  " p r i n t i n g and s t a t i o n a r y . "  B u t i f a g r o s s o f b o t t l e s were  bought, t h e unused s t o c k might p o s s i b l y be c a r r i e d a t t h e end o f t h e p e r i o d as a n a s s e t i n t h e b a l a n c e  forward sheet.  T h i s s h o u l d h e l p t o 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 e x p e n d i t u r e r e a l l y , i s .  C a p i t a l expend-  i t u r e i s e x p e n d i t u r e t h e d i r e c t b e n e f i t s o f w h i c h a r e t o be received i n future accounting periods.  Thus i t i s n o t o n l y  the n a t u r e o f t h e e x p e n d i t u r e b u t t h e l e n g t h o f t h e a c c o u n t ing p e r i o d which i s m a t e r i a l .  Thus a y e a r ' s r e n t p a i d i n  advance o n J a n u a r y 1 i s w h o l l y a c h a r g e t o " r e v e n u e  i n an  57  a c c o u n t p r e p a r e d f o r t h e y e a r ended on t h e f o l l o w i n g December 3 1 ;  b u t i n an a c c o u n t e n d i n g on June 3 0 , o n l y h a l f  t h e amount i s r e v e n u e e x p e n d i t u r e , and h a l f i s c a r r i e d ward as c a p i t a l  for-  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 i n v e s t m e n t c a l c u l a t i o n s .  F o r example, if. a $ 1 , 0 0 0  i t e m i s c h a r g e d as revenue expense i n s t e a d o f b e i n g 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 r e d u c e s income b u t l e a v e s t h e i n v e s t m e n t base u n a f f e c t e d .  I f t h i s i t e m i s . t r e a t e d as an  a s s e t a d d i t i o n , t h e income w o u l d n o t be r e d u c e d , but t h e i n v e s t m e n t base w o u l d be  increased.  Then, i f t h e income had been $ 5 , 0 0 0 on a $ 1 0 0 , 0 0 0 base w i t h o u t i n c l u d i n g t h e $ 1 , 0 0 0 c h a r g e , t r e a t i n g  $1,000  as a r e v e n u e e x p e n d i t u r e p r o d u c e s 4 p e r c e n t r e t u r n on investment.  I f on t h e o t h e r hand, $ 1 , 0 0 0 . i s  t h e i n v e s t m e n t base i n c r e a s e s t o $ 1 0 1 , 0 0 0 , r e t u r n i s 4 . 9 5 per. c e n t .  capitalized,  on w h i c h a $ 5 , 0 0 0  These f l u c t a t i o n s i n t h e r a t e o f  r e t u r n a r e m a g n i f i e d because s u c h i t e m s , 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  figure. Choice of gross or net f i x e d a s s e t s .  1958  I n t h e March  i s s u e o f N.A.A. B u l l e t i n , t h e f o l l o w i n g arguments were  used i n f a v o u r o f the gross f i g u r e f o r f i x e d  assets:  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 t h e 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 t h o s e 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 l o w c o s t and t h o s e 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 . 2. A s s e t s o f 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, a r e c o n s i d e r e d t o be on a c o n t i n u i n g  58  "basis r a t h e r t h a n d e p l e t e d and  abandoned.  3. Gross a s s e t s o f one p l a n t c a n be compared w i t h t h o s e o f a n o t h e r 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. R e s e r v e f o r d e p r e c i a t i o n i s not d e d u c t e d f r o m 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 b u s i n e s s o f the f u n d s r e q u i r e d t o keep i n t a c t the o r i g i n a l i n v e s t m e n t by s t o c k h o l d e r s . A c t u a l l y t h e f i x e d a s s e t s a r e used t o p r o d u c e 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 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 d e d u c t i o n f o r l i a b i l i t i e s and r e s e r v e s f r o m t h e 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 i n v e s t m e n t due t o g r o w t h o f r e s e r v e s and change i n amount o f s t o c k h o l d e r c a p i t a l w h i c h , i n t u r n , w o u l d produce s u c h a d i s t o r t i o n i n t h e r e t u r n on i n v e s t m e n t as t o r e n d e r i t meaningless... The  f o l l o w i n g r e a s o n s were advanced f o r t h e use  of  net  assets: 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 unders t a t e d a t the p r e s e n t t i m e , t h e wrong method o f i n c r e a s i n g i t cannot be r e l i e d on t o f u r n i s h the r i g h t r e s u l t s and t h e a t t e m p t can o n l y add t o 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 . 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 t o the g r o s s a s s e t s , amounts t o o v e r s t a t i n g the i n v e s t m e n t . 2. F i x e d a s s e t s a r e shown a t n e t d e p r e c i a t e d 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 .  values  3. An i n v e s t m e n t i s s o m e t h i n g s e p a r a t e and d i s t i n c t f r o m the media t h r o u g h w h i c h i t was made. The p u r c h a s e 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 o f • R e t u r n on I n v e s t m e n t (N.A.A. B u l l e t i n , M a r c h , 19587, pp.25-2o"7  59 p r i c e o f a machine s h o u l d he r e g a r d e d as t h e p r e p a i d c o s t f o r t h e number o f y e a r s o f p r o d u c t i o n e x p e c t e d . I t s v a l u e , and hence t h e l i m i t s t o i t s i n v e s t m e n t s t a t u s a t any time t h e r e a f t e r , w i l l depend n o t on i t s c u r r e n t m e c h a n i c a l e f f i c i e n c y h u t oh t h e number o f y e a r s o f f u t u r e p r o d u c t i o n i t c a n p r o m i s e . Each y e a r t h i s number w i l l d e c l i n e and t h e d e c l i n e s h o u l d be o f f s e t by c a s h w i t h h e l d f r o m g r o s s r e v e n u e s . The f u n c t i o n o f d e p r e c i a t i o n a c c o u n t i n g i s t o maint a i n t h e a g g r e g a t e 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 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 a s s e t consumption ( d e p r e c i a t i o n ) o f t h e year... These arguments f a l l (1)  i n t o t h r e e eatagor.ies:  E n s u r i n g c o m p a r a b i l i t y o f one d i v i s i o n w i t h  a n o t h e r o r one company w i t h a n o t h e r ; (2)  establishment of a "true" rate of r e t u r n ;  (3)  r e f l e c t i o n o f changes i n t h e . r a t e o f r e t u r n by  changes i n m a n a g e r i a l p e r f o r m a n c e . Inter-company  and i n t r a - c o m p a n y  comparisons.  Arguments (1 ) and ( 3 ) f o r t h e use o f g r o s s a s s e t s and a r g ument ( 1 ) f o r t h e use o f n e t a s s e t s a r e i n f a v o u r o f e s t a b l i s h i n g i n v e s t m e n t base w h i c h w i l l be comparable d i v i s i o n t o d i v i s i o n and between companies. f o r gross assets a r e :  1  I b i d . , p. 26.  from  The arguments  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 a n d t h o s e 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. G r o s s a s s e t s o f one p l a n t c a n be c o m p a r e d w i t h t h o s e o f a n o t h e r p l a n t w h e r e 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 n e t a s s e t s  seeking  t h e same r e s u l t  is: 1. While invested c a p i t a l i s c o n v e n t i o n a l l y unders t a t e d a t t h e p r e s e n t t i m e , t h e wrong method i f i n c r e a s i n g i t c a n n o t be r e l i e d o n t o f u r n i s h t h e r i g h t r e s u l t s and t h e attempt c a n o n l y ' a d d t o t h e e x i s t i n g confusion i n accounting thinking. C a s h 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 t h e g r o s s a s s e t s , amounts t o o v e r s t a t i n g t h e i n v e s t m e n t . The in  order  arguments f o r g r o s s  assets  should  be c o m p a r a b l e .  to reduce  the e f f e c t of i n f l a t i o n  different  depreciation  The  o f investment  It  a n d d i s t o r t i o n s due t o  methods.  bases,  i s desirable  such c o m p a r a b i l i t y  also  but says  by t h e use o f o r i g i n a l  between companies  Eliminating  O r i g i n a l . c o s t i s advocated  argument:: f o r n e t a s s e t s  accomplished  the  that  t o compare two c o m p a n i e s o r . d i v i s i o n s , t h e i n v e s t -  ment b a s e s  ability  say i n e f f e c t  aims a t compar-  that  this  c a n n o t be  cost.  t o have v a l u a t i o n bases  comparable  and d i v i s i o n s , b u t i t i s d o u b t f u l c a n be a c h i e v e d  depreciation  problem but only  whether  by t h e use o f g r o s s  from consideration  adds c o n f u s i o n .  assets.  does n o t s o l v e  What i s n e e d e d  i s the'  61 current of  valuation  of  assets  rather  fluctuations in price levels  accepting cost  was  of  original  The gross  correct asset  passage  tween the  hy  ignoring  a f a r - f e t c h e d f i g u r e of gross the  With the  than a r t i f i c a l  third  assets  time, cost  value there  and  the  at  assets.  the  time  i s a growing current  asset  argument, a l t h o u g h r i g h t  basis  of v a l u a t i o n ,  is  misapplication  not it  amounts t o  built  up  Current of  the  i n other  rate  overstating  accounting  to await  i s invested  kind  of  of r e t u r n .  f o r the  of gross  net  assets.  The  use  The  ideas.  and original  purchase.  disparity  be-  value. criticizing, that,  i f added.to  the  investment." Cash  is  This  certainly  of;depreciated  asset;  assets.  of r e t u r n  (4)  the  replacement  '.'true" r a t e  and  in  of  facts  i s wrong i n s t a t i n g  "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 , gross assets,  the  smoothing  Establishment  i s sought assets  and  arguments f o r g r o s s a s s e t s  by  of  some  arguments  argument  (3)  (2) for  are:  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, a r e c o n s i d e r e d t o - b e on a c o n t i n u i n g b a s i s r a t h e r t h a n d e p l e t e d and a b a n d o n e d . 4. Reserve f o r d e p r e c i a t i o n i s not deducted f r o m the g r o s s a s s e t v a l u e 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 b u s i n e s s of the funds r e q u i r e d to k e e p i n t a c t t h e o r i g i n a l i n v e s t m e n t by stockholders. 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 i n c o m e 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 assets are r e t i r e d from use.  62  The argument f o r n e t a s s e t v a l u a t i o n a i m i n g a t a "true" rate of return i s : 3. An i n v e s t m e n t i s something' s e p a r a t e and d i s t i n c t f r o m t h e media t h r o u g h w h i c h i s was made. The p u r c h a s e p r i c e o f a machine s h o u l d he r e g a r d e d as t h e p r e p a i d c o s t f o r a number o f y e a r s o f p r o d u c t i o n e x p e c t e d . I t s v a l u e , and hence t h e l i m i t t o i t s i n v e s t m e n t s t a t u s a t any t i m e t h e r e a f t e r , w i l l depend n o t on i t s c u r r e n t m e c h a n i c a l e f f i c i e n c y b u t t h e number o f y e a r s o f f u t u r e p r o d u c t i o n i t c a n p r o m i s e . Each y e a r t h i s number w i l l d e c l i n e and t h e d e c l i n e s h o u l d be o f f s e t by c a s h w i t h h e l d from gross revenue. The f u n c t i o n o f d e p r e c i a t i o n a c c o u n t i n g i s t o m a i n t a i n t h e a g g r e g a t e 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) t o r e p l a c e the aggregate a s s e t consumption (depreciation) of the year. The arguments i m p l y t h a t a t r u e r a t e o f r e t u r n c a n be a r r i v e d a t by computing i s maintenance to  i t from a c e r t a i n standard which  of o r i g i n a l c a p i t a l intact.  This i s s i m i l a r  t h e economic c o n c e p t o f income w h i c h i s e x p r e s s e d as t h e  maximum amount t h a t c o u l d be consumed and s t i l l l e a v e t h e i n d i v i d u a l o r e n t i t y as v / e l l o f f a t t h e end o f t h e p e r i o d as a t t h e b e g i n n i n g . It  i s , i m p o r t a n t f o r t h e measure t o be a c c u r a t e ;  t h i s a c c u r a c y , however, i s a c h i e v e d by n e i t h e r a r a t i o o f income t o g r o s s a s s e t s n o r t o n e t a s s e t s .  N e i t h e r accounts  for: (1)  Income d e r i v e d f r o m r e i n v e s t e d f u n d s r e c o v e r e d  through d e p r e c i a t i o n charges.  63 (2)  .Timing and shape o f e a r n i n g s r e c e i v e d o r t o  he r e c e i v e d f r o m c u r r e n t i n v e s t m e n t . (3)  Changes i n p r i c e  levels.  The above t h r e e f a c t o r s c a n be a c c o u n t e d f o r by •estimating-the time curve o f f u t u r e gross r e c e i p t s o f a b u s i n e s s and f u t u r e g r o s s payments and d i s c o u n t i n g them t o t h e p r e s e n t . T h i s i n v o l v e s , however, c h o i c e o f a p p r o p r i a t e d i s c o u n t r a t e and f o r e c a s t i n g o f r e v e n u e s and e x p e n d i t u r e s . T h e o r e t i c a l l y , t h i s v i e w has much t o commend it. 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 t h e words o f George 0. May: ... t o a c c e p t a ' d i s c o u n t i n g o f t h e f u t u r e method o f i m p l e m e n t i n g t h e - c o n c e p t w o u l d be w h o l l y u n a c c e p t a b l e t o them; f i r s t , because i t would i n v o l v e c o u n t i n g c h i c k e n s b e f o r e t h e y a r e h a t c h e d ; and s e c o n d l y because i t c o n t e m p l a t e s t h e u s e o f e s t i m a t e s and d i s c o u n t r a t e s t h a t n e c e s s a r i l y a r e s u b j e c t i v e , c o n j e n c t u r a l , and unverifiable.^ 1  The t h i r d argument needs a s p e c i a l comment as i t leads to confusion of accounting concepts.  Depreciation  i s confused here w i t h f i n a n c i n g o f replacement.  Basic  purpose o f a c c r u i n g d e p r e c i a t i o n i s c o n c e i v e d by t h i s argument.as a c c u m u l a t i o n o f f u n d s t o p r o v i d e f o r t h e r e n e w a l of the assets.  A t b e s t , t h i s i n o n l y h a l f - t r u t h w h i c h may  l e a d t o erroneous c o n c l u s i o n s .  The r e a l purpose o f d e p r e c -  i a t i o n i s m a t c h i n g o f p e r i o d i c c o s t s and r e v e n u e s .  George 0. May, "Concepts o f B u s i n e s s Income and T h e i r I m p l e m e n t a t i o n , " The Q u a r t e r l y J o u r n a l o f Economics, F e b r u a r y , 1954, p.3. -  64 As s t a t e d by P a t o n and L i t t l e t o n : The b o o k i n g o f 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 t o t h e p r o b l e m o f r e p l a c e m e n t . I f p e r i o d i c income i s t o be p r o p e r l y measured i t " i s n e c e s s a r y t o match r e v e n u e 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 q u i r e m e n t r e m a i n s i n f o r c e even i f t h e r e i s n o v p r o s p e c t that other generations•of 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 f u n d s a r e p r o v i d e d by t h e process of accruing d e p r e c i a t i o n . I t i s through the revenue s t r e a m o f r e a l i z e d p r o d u c t i o n t h a t t h e f i n a n c i a l s i n e w s a r e renewed and i n g e n e r a l i t i s f a i r t o s a y t h a t t h e s i z e o f t h e s t r e a m i s n o t a f f e c t e d by t h e amount o f a s s i g n e d cos't.^ I n l i n e w i t h t h i s argument, t h e n e t f i x e d a s s e t base seems t o be l o g i c a l t o use i n t h e r a t e o f r e t u r n on i n v e s t m e n t measure; i t i s c o n s i s t e n t w i t h income d e 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 c a s e s , g r o s s f i x e d a s s e t f i g u r e may be b e t t e r t o use t o 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 retirement of f a c i l i t i e s . When t h e g r o s s v a l u e i s used i n the investment base, the r e t i r e m e n t o f . a fixed asset t a k e s t h e o r i g i n a l c o s t o u t o f t h e d e n o m i n a t o r , and so t a k e s out a g r e a t e r f i g u r e t h a n t h e n e t a s s e t v a l u e . Management w i t h a n eye. t o an o p e r a t i n g r a t e o f r e t u r n w i l l be e n c o u r a g e d by t h i s t o r e t i r e a s s e t s w h e r e v e r i t f i n d s t h a t improvements i n t h e r a t e o f r e t u r n c a n be made.,.  1  W.A. P a t o n and A.C. L i t t l e t o n , A n I n t r o d u c t i o n To C o r p o r a t e A c c o u n t i n g S t a n d a r d s (American"Accounting' A s s o c i a t i o n Monograph No. 3, 1 9 5 7 J , p.59. 2 W i l l i a m R o t c h , " R e t u r n on I n v e s t m e n t 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 , 1 9 5 8 ) , 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  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 o f t h e o l d e r and  are newer  facilities: Second, f i x e d a s s e t s a r e t a k e n 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 of t h e company, some o f w h i c h may have new a s s e t s and o t h e r s 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 . T h i s too i s c o r r e c t i n g " o n l y one phase o f a p r o b l e m . 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 m a i n t e n a n c e t h a n new o n e s . The use o f 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 c o s t and t h u s l o w e r profits. I f t h e s e a r e 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 o f a newer u n i t . * A l t h o u g h g e n e r a l l y t h i s i s . t r u e , i n the case o f 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  a r e overcompensated and any h i g h rate, of r e t u r n .  income p r o d u c e s an  T h i s i s due  facilities extremely  t o an i n c o r r e c t e s t i m a t e  o f t h e . u s e f u l . l i f e o f an a s s e t i n the f i r s t p l a c e . ically,  an  Theoret-  t h i s c a n be r e m e d i e d by an a d j u s t m e n t o f p a s t  income;  i n p r a c t i c e , t h e . a d j u s t m e n t i s made by a c h a r g e t o d e p r e c i a t i o n allowance  and a c r e d i t t o income i n the p e r i o d when the  determination  o f a c o r r e c t net v a l u e o f an a s s e t i s made.  T h i s v i t i a t e s c o m p a r i s o n o v e r t i m e and  therefore.should  be  allowed 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 o f p e r f o r m a n c e changes i n t h e r a t e o f r e t u r n on i n v e s t m e n t .  Argument ( 5 )  f o r t h e use  of  gross  '-assets s t a t e s t h a t :  1  I.Wayne K e l l e r , Management A c c o u n t i n g P o r P r o f i t C o n t r o l (New Y o r k : M c G r a w - H i l l , 1 9 5 7 ) , pp. 315-316'.  66 A d e d u c t i o n f o r l i a b i l i t i e s and r e s e r v e s f r o m t h e 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 w o u l d show a f l u c t u a t i o n i n o p e r a t i n g i n v e s t m e n t due t o g r o w t h o f r e s e r v e s and changes i n amount o f s t o c k h o l d e r c a p i t a l w h i c h , i n t u r n , w o u l d produce s u c h a d i s t o r t i o n i n t h e r e t u r n on i n v e s t m e n t as t o r e n d e r i t m e a n i n g l e s s . T h i s argument i s sound i n p r i n c i p l e . Any change i n p e r f o r m a n c e s h o u l d be r e f l e c t e d i n t h e change o f t h e r a t e o f r e t u r n on i n v e s t m e n t . I t i m p l i e s , however, a d i m i n u t i o n i n i n v e s t m e n t base t h r o u g h d u d u c t i o n o f accumu l a t e d , r e s e r v e s and f o r g e t s t h a t t h e s e r e s e r v e s , a r e r e p r e s e n t e d by some a s s e t s i n the b u s i n e s s . M o r e o v e r , a c o n t i n u i n g b u s i n e s s 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 p r u c h a s e s , w i l l have, a p p r o x i m a t e l y , the same p e r c e n t a g e o f n e t t o g r o s s f i x e d a s s e t s ; and, u n l e s s i t changes i t s e x p a n s i o n r a t e , t h e r a t e o f r e t u r n on i n v e s t m e n t w i l l not be d i s t o r t e d . E f f e c t o f g r o s s o r n e t a s s e t s on r a t e o f r e t u r n on investment.  The  c h o i c e between the g r o s s and n e t v a l u e  f i x e d a s s e t s a f f e c t s t h e r a t e o f r e t u r n on i n v e s t m e n t  of  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. T a b l e I I I shows t h e magnitude o f t h e w h i c h may  discrepancy  a r i s e between c o m p u t a t i o n s o f the r a t e o f r e t u r n  on the g r o s s and n e t i n v e s t m e n t .  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 t h e t a b l e i f a n n u a l net income i s p e r m i t t e d t o f l u c t u a t e w i t h t h e net average i n v e s t m e n t t h e . y e a r , i . e . , i f i n s t e a d o f a c o n s t a n t net a n n u a l  for  income o f  $10,000 p e r 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 o f the a s s e t s . a l s o , i g n o r e s new  The  a d d i t i o n s o f a s s e t s w h i c h i s the u s u a l  table,  67 TABLE I I I Comparison o f Rate With  Rate  fl  -p fl ©  o a © t>  c3  H  H-H  CD H  o O  TTT  +» © +» ©  cn ©  3 s ©°  •p ca  o  13 CP -pc3  cd  ft ©  •p d © fl & W  Cd CO r H ©  cost  a)  3  TTT  $87,500 62,500 37,500 12,500 0  $10,000 10,000 10,000 10,000 35,000  (2)  D e p r e c i a t i o n based  CQ ©  w  TTT  Original  +» fl  ail  © > h  (1)  +> fl a © © 2 rH  > fl O  9  of Return  ©  o +»  H  ttf-p ©  9  years;  (3  © £  $ 1 0 0 0 0 0 $25,000 $75,000 100,000 50,000 50,000 100,000 75,000 25,000 1 0 0 0 0 0 100,000 0 1 0 0 , 0 0 0 100,000 0  Rate  -p ©  fl <H H o  TTT  T2T  Assets  o f R e t u r n on Net Assets,.  T3 O 0) -H ^> -P  eS  o f R e t u r n on GTOSB  10% 10% 10% 10% 35*  s  © •p -p © ©  fl o ~T77  11,42% 16,00% 26,60% 80.00% Infinite.  of assets,  straight-line  on expected l i f e  used.  of four  Assets actually  were  used  for five  (3)  C o l u m n (1) m i n u s C o l u m n ( 2 )  (4)  Net i n v e s t m e n t a t b e g i n n i n g o f y e a r p l u s n e t  investment  a t end o f y e a r d i v i d e d  ( e . g . $100.000 (5)  years,  +  $75,000  »  by two  $87,500)  Assumed c o n s t a n t income f i g u r e  B e c a u s e no d e p r e c i a t i o n  c h a r g e was  year,  rises  t h e income f i g u r e  o f $10,000, made i n t h e  fifth  t o $35,000 i n t h a t  (6)  Column (5) d i v i d e d  by Column ( l )  (7)  Column (5) d i v i d e d  b y Column ( 4 ) .  year,  68 occurence  in practice.  r e t u r n on  net  gross  Under these  a s s e t s may  c o n d i t i o n s the r a t e  c o n c e i v a b l y be  the  same a s  I f a. c o n s t a n t  standard  is  f r o m w h i c h t o measure the r a t e o f r e t u r n , the gross  and  method  net  Neither assets  asset  each y e a r  are  probably  during  the  life  of  the  example, gross  i f earnings  penalized  by  base.  this  i f age  assets  On  relating  the  decline with  case,  has  i n f l u e n c e on  no  base p r o v i d e s  age,  and  declining net  The  assets  assets  gross  with  arguments f o r  net  fact  to  other  earning  power t o a  a r e most l i k e l y  to  base  causes.  older f a c i l i t i e s  earning  are constant reflect  power d o e s g e n e r a l l y  a r e more l i k e l y  assets, provided  the  one  to r e f l e c t  period  measures o f . t h e  The  net  base, although  or  by  understatement  occurs.  i s , however, t h a t b o t h  imperfect  the  depreciation allow-  stream of s e r v i c e s rendered  are  asset  earning  a more r e l i a b l e  a. minimum o f o v e r s t a t e m e n t  d e p r e c i a t i o n i n any  rate  on  power.  net  power t h a n  assets  age,  assumption that  ance c o r r e s p o n d s the  which  facilities.  nor  decline with  correct earning  earning  between  book r e t u r n  assets  i d e n t i f y i n g v a r i a t i o n s i n i n c o m e due  In  choice  convincing.  power, t h e  the  on  imposed  depend on  to produce a constant  arguments f o r g r o s s  Por  of  base s h o u l d  i s more l i k e l y  investment  But,  that  investment. Conclusions .  for  of  gross  economic v a l u e i t does n o t  o f r e t u r n , i s more c o n s i s t e n t w i t h  and of  assets  equipment.  establish the  net  a  "true"  definition  of  69 income t h a n t h e g r o s s a s s e t h a s e .  I t i s a l s o t h e amount  t h a t appears i n p u b l i s h e d s t a t e m e n t s . . I . Wayne K e l l e r  suggests t h a t :  The p r i m e danger i n d e p a r t i n g f r o m t h e p u b l i s h e d f i n a n c i a l s t a t e m e n t s i s t h a t management t i m e , w h i c h s h o u l d be d e v o t e d t o h o l d i n g and i m p r o v i n g t h e r a t i o s , w i l l be d i v e r t e d t o a t t a c k s upon t h e v a l i d i t y o f t h e amount o f c a p i t a l i n d e t e r m i n i n g t h e r a t i o s . * The m a j o r i t y o f i n f o r m e d o p i n i o n . s e e m s t o f a v o u r the  use o f net a s s e t s i n the investment base.  S e s e a r c h R e p o r t 35 i s s u e d i n 1959 s t a t e s  H.A.A.  that:  ... f i e l d i n t e r v i e w s i n t h i s s t u d y show t h a t 18 out o f 28 companies u s i n g t o t a l a s s e t s as t h e i n v e s t ment base.do deduct, a c c u m u l a t e d 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 w h o l e , - t h e  aggregate  n e t a s s e t s f i g u r e t e n d s t o be s t a b i l i z e d by r e i n v e s t m e n t o f c a p i t a l r e c o v e r e d o r even i n c r e a s e d by a d d i t i o n a l i n v e s t m e n t s . R e t e n t i o n o f - r e c o v e r e d c a p i t a l i n t h e company t e n d s t o o f f set  t h e r e d u c t i o n o f 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 o f r e t u r n on i n v e s t m e n t . Where t h e p r o p e r g u i d a n c e o f d i v i s i o n managers i s t h e  m a i n o b j e c t i v e , g r o s s a s s e t s may be u s e d t o encourage  early  r e t i r e m e n t s and r e p l a c e m e n t s and n e t a s s e t s may be u s e d t o discourage such r e t i r e m e n t s .  1 I . Wayne K e l l e r , "The R e t u r n on C a p i t a l N.A.A. B u l l e t i n , March, 1958, p. 17.  Concept,"  2  R e t u r n on C a p i t a l as a. Guide t o M a n a g e r i a l D e c i s i o n s (N.A.A. R e s e a r c h R e p o r t 35, 1959), p . l l .  70  CHAPTER V I I USES OP THE RATE OP RETURN ON INVESTMENT The main uses o f t h e r a t e o f r e t u r n on i n v e s t m e n t t h a t were c o n s i d e r e d i n t h i s paper c o n c e r n e v a l u a t i o n o f b o t h company and d i v i s i o n a l p e r f o r m a n c e .  The two unanswered  q u e s t i o n s posed a t t h e beginning- o f t h i s p a p e r a r e : 1. Does t h e use. o f t h e r a t e o f r e t u r n on i n v e s t ment l e a d t o any b e t t e r performance ? 2. Does t h e r a t e o f r e t u r n on i n v e s t m e n t i d e n t i f y good and bad p e r f o r m a n c e and p o i n t t o where p e r f o r m ance c a n be improved ? I f t h e r a t e o f r e t u r n on i n v e s t m e n t does n o t l e a d o r might n o t l e a d t o any b e t t e r p e r f o r m a n c e , t h e n a v e r y good reason f o r i t s adoption i s missing.  A l s o , i f i t does n o t  h e l p i n i d e n t i f y i n g good and bad p e r f o r m a n c e , i t cannot.Lbe u s e d as a g u i d e t o a c t i o n n o r c a n i t be u s e d i n e v a l u a t i n g managerial performance. Even i f i t i s c o n c l u d e d t h a t t h e r a t e o f r e t u r n on i n v e s t m e n t i s a good measure o f p e r f o r m a n c e , e v a l u a t i o n o f r e s u l t s must be s t i l l u n d e r t a k e n .  This implies  determination,  c o n s c i o u s o r u n c o n s c i o u s , o f s t a n d a r d s 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 rate of return.  Because o f 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 p e r f o r m a n c e , s t a n d a r d s 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 of  r e t u r n on  things order are  that  i n performance  investment. "both d i v i s i o n  to improve  the things  that  rate  on  respect  i s reasonable  to f i x e d  generally,  opportunity  assets.  incentives  i n s e e k i n g improvements  The guide  another,  In replacements decisions  Selection of  rate  of r e t u r n  on  lead  the  in  action  of f i x e d  however, a c e r t a i n l e v e l  of  with high  to a b e t t e r  level  one  an return  income performance.  can a l s o  from  b e e n d e c i d e d on,  rather  with  assets  be  level  1 5 t o 2 0 days s u p p l i e s .  has  d e c i s i o n but  the r a t e  investment  inventory  f o r example, f r o m  on  investments  undoubtedly  i n changing  investment  a different  i n c a p i t a l b u d g e t i n g , managers have  contributions w i l l  an  proper  these  i n d u c e managers t o use  to expect  to base t h e i r  calculations.  ful  to  do;  in  performance.  It and,  do  I t does n o t mean t h a t  applied  investment  rate  t o p management m i g h t  management w i l l  must be  of r e t u r n  and  of  f o l l o w i n g a r e some o f the-  performance.  and m o t i v a t i o n  their  The  through, use  a  use-  to Once,  i t i s no  longer  c a r r y i n g out of p r e v i o u s  decision.  S i m i l a r l y with accounts terms,  when t h i s  of r e t u r n  on  i s possible, w i l l  influenced  J . M u t h i n d i c a t e d t h e way  c a n be u s e d  the r i g h t  be  The  change  of  by  rate  the  investment.  Frederick return  receivable.  products:  to improve  profitability  the r a t e by  of  choosing  72 Because o f t h e many p r o d u c t s i n t h e A r m s t r o n g l i n e , i t was r e c o g n i z e d t h a t t h e approaches t o 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 g u i d e 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 s u g g e s t e d t h a t a l l p r o d u c t s he c l a s s i f i e d under t h r e e categories: (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) t h o s e e a r n i n g a modest r e t u r n , and (3) t h o s e e a r n i n g an u n s a t i s f a c t o r y r e t u r n o r showing a l o s s . O b v i o u s l y , 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 s h a r e o f t h e company's b u s i n e s s t h a t i s done i n t h e s e p r o f i t a b l e e n t e r p r i s e s . T h i s i s implemented by s t r i v i n g t o i n c r e a s e s a l e s volume t h r o u g h 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 p r o m o t i o n , and i n v e s t m e n t 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 c a n be s o l d . These comm o d 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 t o d e v e l o p new uses and m a r k e t s . They a l s o a r e s t u d i e d t o a n a l y z e c h a r a c t e r i s t i c s w h i c h c a n p o s s i b l y be matched i n o t h e r commodities t o promote.the development and o f f e r i n g o f companion p r o d u c t s o r o t h e r i t e m s s e r v i n g t h e same o r s i m i l a r markets. Items i n C a t e g o r y 2 a r e s t u d i e d t o seek ways by > w h i c h t h e y might be improved i n t o t h e more p r o f i t a b l e C a t e g o r y 1 t h r o u g h some c o m b i n a t i o n o f t h e f o l l o w i n g approaches. 1.  Cost r e d u c t i o n  2.  S a l e s p r e s s u r e f o r i n c r e a s e d volume.  3.  , Higher sales p r i c e s .  4. R e d u c t i o n i n c a p i t a l employed t h r o u g h r e d u c e d i n v e n t o r y o f f i n i s h e d goods, goods i n p r o c e s s 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 o f u n n e c e s s a r y 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 i t e m s , i f any, w i t h i n t h e commodity or product l i n e . Any commodity o r p r o d u c t group i n C a t e g o r y 3 i s a d r a g on t h e 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 n o t p r o v i d e an adequate r e t u r n t o 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 g r o w t h ; t h e r e f o r e , a l l p r o d u c t s i n C a t a g o r y 3 a r e k e p t under c l o s e s c r u t i n y i n an a t t e m p t t o a c h i e v e , as p r o m p t l y 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 o f t h e commodity.P a u l W. L y o n has d e s c r i b e d  i n his article  "Operat-  i n g R e t u r n on O p e r a t i n g I n v e s t m e n t " how h i s company, West V i r g i n i a P u l p - a n d P a p e r Company, improved p e r f o r m a n c e t h r o u g h a p p l i c a t i o n o f t h e r a t e o f r e t u r n on i n v e s t m e n t : A f t e r l o c a l i z i n g o u r problems i n p e r f o r m a n c e among o p e r a t i n g u n i t s , we began t o use o u r 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 operating 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 t o d e v e l o p c o s t i n f o r m a t i o n w h i c h w o u l d show what r a t e o f r e t u r n on. i n v e s t m e n t any g i v e n grade of p a p e r w o u l d y i e l d on any g i v e n machine i n each o f our m i l l s . A g a i n , as when comparing- one " m i l l a g a i n s t a n o t h e r , we f o u n d t h a t t h e r e were s i z a b l e ' d i f f e r e n c e s i n t h e 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 w h i c h had some r e l a t i v e l y m a r g i n a l g r a d e s , we found! o r d e r s o f magnitude o f s i x o r seven' t o 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 e x p r e s s e d by r a t e o f r e t u r n on i n v e s t m e n t . I n many c a s e s , t h e s e 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 w o u l d n o t have been u n c o v e r e d had we u s e d 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 g r a d e s o f paper w h i c h show b e t t e r m a r g i n s o f p r o f i t on s a l e s t h a n o t h e r g r a d e s w h i c h c a n be p r o d u c e d on.the same equipment. Yet, because o f d i f f e r e n c e s i n t h e amounts o f p a p e r w h i c h 1  F r e d e r i c k J . Muth, " R e t u r n on I n v e s t m e n t — T o o l o f Modern Management," Improved T o o l s o f F i n a n c i a l Management (New Y o r k : A m e r i c a n 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 p r o d u c e d p e r h o u r , t h e r a t e o f r e t u r n on i n v e s t ment y i e l d e d by t h e g r a d e w i t h l o w e r m a r g i n o f 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 . ^ W i t h a p r o p e r a l l o c a t i o n o f i n v e s t m e n t and c o s t s , t h e same a n a l y s i s c a n 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 t o p l a n t and s u b - u n i t s o f a company. I t does n o t mean, however, t h a t t h e use o f t h e r a t e o f r e t u r n on i n v e s t m e n t measure i s an i n s u r a n c e a g a i n s t p o o r d e c i s i o n s ; what i s advanced i s that through c e r t a i n kinds o f a c t i o n , s i m i l a r t o those d e s c r i b e d above, a n improvement i n t h e r a t e o f r e t u r n , i f any, c a n 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 o f t h e r a t e o f r e t u r n on i n v e s t m e n t on managers.  It  may s y m b o l i z e t o them independence and t h u s r e s u l t I n improved performance.  Powered w i t h t h e r i g h t i n c e n t i v e , . t h e r a t e o f  r e t u r n on i n v e s t m e n t may become a p o t e n t  force.compelling  managers t o l o o k f o r improvements i n p e r f o r m a n c e .  There i s  n o t , however, s t a t i s t i c a l e v i d e n c e t h a t t h i s i s t h e c a s e ; s u c h p o s s i b i l i t y s h o u l d n o t be r u l e d o u t . W i l l i a m R o t c h t h i n k s , however, t h a t t h e f e e l i n g o f independence i s s h o r t l i v e d and t e n d s t o be o v e r r a t e d  by t o p management who assume  t h a t t h e r a t e o f r e t u r n on i n v e s t m e n t g i v e s s u b o r d i n a t e s  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. L y o n , " O p e r a t i o n R e t u r n on O p e r a t i n g I n v e s t ment ," Improved T o o l s o f , F i n a n c i a l Management (New Y o r k : A m e r i c a n 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: 1 1 1 , 1 9 5 6 ) , p..20. 2 ' W i l l i a m R o t c h , " R e t u r n on I n v e s t m e n t as a Measure o f Performance." ( U n p u b l i s h e d D o c t o r ' s D i s s e r t a t i o n , H a r v a r d U n i v e r s i t y , 1 9 5 8 ) , pp. 55-56.  75 The on  conclusion  i n v e s t m e n t may i d e n t i f y  may l e a d  to a better Problems  investment. of r e t u r n against Keller and  i s that  performance.  Appraisal  the rate  o f performance  suggests  o f r e t u r n on i n terms o f t h e r a t e  c e r t a i n optimum s t a n d a r d s o f p e r f o r m a n c e  which a c t u a l performance says that  of return  good and bad performance and  i n evaluating  implies  the use o f r a t e  i s measured.  I . Wayne  no f o r m u l a h a s b e e n d e v e l o p e d  t o do  this  c e r t a i n ways o f 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 a r e t o be m e a s u r e d a n d c o n t r o l l e d , t h e r e s h o u l d be some m e t h o d o f d e t e r m i n i n g - t h e optimum a n d t h e maximum r e t u r n o n c a p i t a l e m p l o y e d . Unfortunately, no f o r m u l a h a s b e e n d e v e l o p e d w h i c h v / i l l do t h i s , judgment, based on comparisons w i t h o t h e r companies and t h e e x p e r i e n c e o f t h e company, i s t h e o n l y m e t h o d o f s e l e c t i n g optimum a n d 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 m a j o r f a c t o r s t o be c o n s i d e r e d are: 1.  The b e s t  and t h e average r e t u r n s  2.  The b e s t  and average r e t u r n s  3.  The company p o s i t i o n i n t h e 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 p r o c e s s e s o f t h e company.  and  o f a l l companies.  of similar industries.  of patents  or secret  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 becoming s i g n i f i c a n t competitors  the f i e l d  M  William determination enterprize  J . Vatter  i n discussing  the problem o f  o f a normal r e t u r n f o r the r i s k  states  that  this  question  of a  given  is:  1 I . Wayne K e l l e r , Management A c c o u n t i n g f o r  Gontrol  (NewYork: McGraw-Hill7 1 9 5 7 ) , p.317.  Profit  76 ... a n s w e r a b l e o n l y i n t e r m s o f a v e r a g e s o r c o m p a r i s o n s w i t h o t h e r f i r m s , t h e r e i s no way t o 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 t h e r a t e o f r e t u r n w h i c h j u s t c o v e r s n o r m a l r i s k s o f a n i n d u s t r y . Thus o u r r a t e o f r e t u r n m e a s u r e must a l w a y s be a r e l a t i v e m e a s u r e m e n t , 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 n o t 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 c o m p a r i s o n s 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 a r e drawn.* t  In the o f r e t u r n as must be  of standards  I t i s suggested  o f a company w i t h  i n a p p r a i s i n g management, e . g . , performance w i t h  t h a t of the  Divisions the  can.be  company a s  performance o f . t h i s parisons,  w h o l e must  m i g h t be  take  different  into  compared with, o t h e r  divisions  account  the  c o s t s o f p u t t i n g new  In practice,  accounting  differing  one  and  facilities  Theoretically, easy.  or with  costs i n divisions, by  systems o r ,  year's  divisions, divisional  such not  into  the  as  by  These  com-  and-judgment.' company as  risks  in.the  product  the  other,  business  developor  the  other  companies  i s hampered.by d i f f e r e n c e s  i n some c a s e s ,  a  operation.  comparisons w i t h this  useful  year.  a whole, or w i t h  other  to  historical  comparison of t h i s  last  rate  factors  in addition  year with previous years.  ment r e s e a r c h c a r r i e d  are  time  however, r e q u i r e i n t e r p r e t a t i o n  Comparisons w i t h  and  that  other firms, a  o f company p e r f o r m a n c e o v e r  or with  of evaluating- the  a measure o f performance a l l r e l e v a n t  considered.  comparisons review  selection  in  l a c k of p u b l i s h e d  _  Business  W i l l i a m J . V a t t e r "Does t h e R a t e o f R e t u r n M e a s u r e Efficiencyf" N.A.A. B u l l e t i n , January, 1 9 5 9 , p . 3 4 .  77 figures.  A c o m p a r i s o n o f a d i v i s i o n o f one company w i t h  a d i v i s i o n o f a n o t h e r company i s n o t f e a s i b l e because o f lack of rate of return figures. Comparisons o f a company o r a d i v i s i o n w i t h t h e i n d u s t r y a r e easy b u t o n l y u s e f u l t o g e t r o u g h l e v e l s o f r e t u r n . Even w i t h i n a n 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 rates of return. I . Wayne K e l l e r s a y s t h a t , "Companies w i t h h i g h , a v e r a g e , and l o w r e t u r n s a r e f o u n d i n e v e r y . i n d u s t r y . The r e t u r n a c h i e v e d i s t h e r e s u l t o f management, and no company should f e e l that 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 o f a l l companies.".. L a t e r , K e l l e r goes on t o s a y : Because o f t h e s e 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 b r o a d p r o d u c t l i n e s h o u l d n o t e x p e c t t o r e a l i z e t h e same r e t u r n on a l l products. S e p a r a t e o b j e c t i v e s need t o be e s t a b l i s h e d f o r each l i n e and f o r t h e t o t a l company. The maximum a v e r a g e r e t u r n o v e r t h e p e r i o d o f a b u s i n e s s c y c l e s h o u l d n o t be so h i g h 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 c o m p e t i t o r s o r i n v i t e s new competition.As a r u l e o f thumb, i t would appear t h a t a r e t u r n on c a p i t a l o f 2 0 % i n a p r o d u c t l i n e i s a l m o s t t h e maximum t h a t s h o u l d be e x p e c t e d t o be h e l d o v e r a p e r i o d o f y e a r s , even w i t h p a t e n t p r o t e c t i o n . F o r t o t a l company r e t u r n , t h e h i s t o r i c a l p a t t e r n i s a range o f f r o m 1 0 % t o 1 5 % f o r companies w h i c h a r e g e n e r a l l y c o n s i d e r e d t o be s u c c e s s f u l g r o w t h companies.2 "  \  '  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 C o n t r o l (New Y o r k : M c G r a w - H i l l , 1 9 5 7 J , p. 317. 2 I b i d . , pp. 318-319.  78 I n v i e w o f t h e a b o v e comments, standards  seems t o be n o t a s u f f i c i e n t  evaluation  i n terms o f t h e r a t e  o t h e r companies  i n t h e same  a g e d c o m p a n i e s may company. isions  of return.  industry  company,  i n case  or with  formance over  time,  should guide  divisional profit  the above.quotation, lines  The return  surrounding  the rate  of  a division,  of a divisional  per-  i n establish-  As s u g g e s t e d  by K e l l e r i n  f o r d i f f e r e n t product  i n t o account  problem  i n evaluation  a company,  special char-  i n the use o f r a t e o f o f performance  specific  manner, f o r c e s  i n the l i g h t  conditions  conclusion  or industry  of determining precise  i n a reliable  comparisons  lies i n Reflected  about  i n question. standards  perform-  to Interpret  o f i t s knowledge o f b u s i n e s s and  s u r r o u n d i n g o p e r a t i o n s and.come  what a g o o d r a t e  company p e r f o r m a n c e  ment's e f f e c t i v e n e s s  of  t o p management  a n d , a t t h e same in utilizing  to a  of return i s .  P e r f o r m a n c e a p p r a i s a l o f a company. a  s e t f o r the  of return figure are s p e c i a l c h a r a c t e r i s t i c s  Impossibility ance  decentral-  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 .  in  div-  them.  most i m p o r t a n t  on investment  f o r the  other s i m i l a r  of return  objectives  o r d i v i s i o n s should take  acteristics  that  profit  standards  t o p management  objectives.  with  t h e b e s t man-  of divisions  the rate  company a s a w h o l e , o r c o m p a r i s o n s  t o abandon  Comparisons  or with  Comparisons o f a d i v i s i o n w i t h  i n t h e same  of precise  reason  help to set attainable  ized geographically,  ing  lack  time,  Appraisal of o f t o p manage-  the r e s o u r c e s under i t s  79 c o n t r o l c a n be made i n t h r e e s t a g e s : 1.  P r e s e n t company p e r f o r m a n c e i n r e l a t i o n t o  past performance. 2.  P r e s e n t company p e r f o r m a n c e i n r e l a t i o n t o  performance o f c o m p e t i t o r s . 3.  P r e s e n t company p e r f o r m a n c e i n r e l a t i o n t o  companies n a t i o n a l l y r e c o g n i z e d t o be  well-managed  businesses.^ Por  the purposes of i l l u s t r a t i o n ,  a hypothetical  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 i n v e s t m e n t o f "X" Company f r o m 1953 t o 1958 has been as shown i n T a b l e I V . TABLE IV R e t u r n on Investment o f "X" Company f r o m  1953 t o 1958 Year  1953 1954 1955 1956 1957 1958  P e r c e n t R e t u r n on Investment  11 12 13 9 7 5  The t a b l e shows a d i m i n i s h i n g r a t e o f r e t u r n t o a 1  F r e d e r i c k J . Muth, " R e t u r n on I n v e s t m e n t — T o o l o f Modern Management," Improved.Tools o f F i n a n c i a l Management (New Y o r k : A m e r i c a n Management A s s o c i a t i o n F i n a c i a l Management S e r i e s No: 111, 1956), pp. 5-8.  80 low  figure  necessary  of five  poor r e s u l t s  I t i s , therefore,  —  from g e n e r a l  economic  This  leads  into  "X"  c o n d i t i o n s o r whether  a r e an i n d i c a t i o n o f l e s s e n i n g o f  effectiveness.  with  i n 1958.  t o i n v e s t i g a t e f u r t h e r and determine whether  Company.suffered  parison  p e r cent  t h e next  stage  t h e c o m p a r i s o n o f "X" Company's  managerial o f com-  performance  competition. Comparison w i t h  comparison with  competition.  competition;  Table  V makes t h e  I t shows t h a t , c o m p a n i e s  same i n d u s t r y h a v e n o t s u f f e r e d a d e c l i n e I n t h e i r  i n the  earnings  and,  t h e r e f o r e , t h e 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  rate  o f r e t u r n must be s o u g h t  i n i t s operations.  TABLE V Comparison w i t h  Company  Competition  P e r Gent R e t u r n on Investment  14 12 11 10 9 8 7  A B C D E P G "X" Company  6  .5  1  The Table  results  o f e a c h company a r e b r o k e n down i n  V I i n terms o f the r a t e o f r e t u r n on  investment  formula: Net Income Sales  x  Sales Investment  = R e t u r n on Investment  81 TABLE 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 chosen companies i n t h e same i n d u s t r i e s p.er c e n t P/ercentage o f R e t u r n on income on Investment Sales Turnover  Company A B C . D E F G "X" Company I  8 6 11 5 3 4 5 4 3  14 12 11 10 9 8 8 '6 5  1.7 2.0 1.0 2.0 3.0 2.0 1.6 1.5 1.6  T a b l e V I r e v e a l s why income on s a l e s i s n o t a good measure o f p e r f o r m a n c e .  Company C has t h e h i g h e s t  income on s a l e s , e l e v e n p e r c e n t , y e t i t . s t a n d s t h i r d i n the r a t e o f r e t u r n on i n v e s t m e n t r a n k i n g . come on s a l e s and t u r n o v e r  By a n a l y s i n g i n -  figures f o r competitive  companies,  i t c a n be f o u n d t h a t , a l t h o u g h "X" Company's income on s a l e s i s . t h e same.as t h a t o f company P and even b e t t e r t h a n t h a t o f company E, i t s t u r n o v e r i t s turnover,  increase  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 -  i n s a l e s may l e a d t o l o w e r c o s t s  b e t t e r u t i l i z a t i o n of existing- f a c i l i t i e s . of operations  By i m p r o v i n g  "X" Company w i l l be a b l e t o r a i s e i t s r a t e o f  r e t u r n on i n v e s t m e n t . dicated;  i s much l o w e r .  through  Detailed analysis,  i n terms o f r a t e o f r e t u r n may h e l p t o u n c o v e r  ways o f i m p r o v i n g p e r f o r m a n c e . Comparison w i t h weII-managed companies. "X"  Finally,  Company c a n be compared w i t h t h e well-managed companies,  82 not n e c e s s a r i l y i n t h e same i n d u s t r y .  P o r the purposes o f  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 f r o m t h e 500 l a r g e s t U.S... I n d u s t r i a l . C o r p o r a t i o n s  appearing i n the Fortune  D i r e c t o r y i n 1959.^ TABLE 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 r e d companies. Company  P e r Cent Rate o f R e t u r n on I n v e s t m e n t 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 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 0  C o m p e t i t i v e companies shown i n T a b l e V, companies A,B,C,D,E, and F, show r a t e s o f r e t u r n f r o m e i g h t p e r c e n t t o f o u r t e e n p e r c e n t ; t h i s compares f a v o u r a b l y w i t h t h e r a t e s o f r e t u r n o f t h e b e s t managed companies. t h a t "X  I t c a n be c o n c l u d e d  Company i s engaged i n an i n d u s t r y w h i c h c a n produce  ?l  a r e t u r n on i n v e s t m e n t e q u i v a l e n t outstanding  t o t h o s e p r o d u c e d by  management o f companies i n T a b l e V I I .  W i t h t h e s e b a s i c d a t a 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 evaluating i t s performance'trend  against  1  The F o r t u n e 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' ( F o r t u n e , J u l y , 1959)» p . 126.  83 past  experience,  group  competition,  of well-managed This  examining  initial  divisional  performance,  and  and  the r e c o r d  of the  selected  companies. diagnosis  must he f o l l o w e d  performance,  so on,  looking  plant  through  performance,  by  product  f o r areas of strengths  and  weaknesses. Appraisal not  possible  because  to e s t a b l i s h the " r i g h t " r a t e  i t i s u s u a l l y not p o s s i b l e  on p e r f o r m a n c e comparisons to  of"other  divisional  review of past  divisions within  of return  to obtain  t h e company, and  and  relevant  data  companies,  performance  performance,  i t is  must be  limited  i . e . , performance to- t h e  performance  company as a w h o l e .  The be  Since  of s i m i l a r d i v i s i o n s i n other  of current  a historical  ofthe  of d i v i s i o n a l performance.  also  analysis  suggested i n the previous  undertaken i n appraising  must be^oiwever,  b o r n i n mind  enumerated e a r l i e r r e t u r n on  d i v i s i o n a l manager. experience,  Frederick  d i v i s i o n a l manager's  can  d i v i s i o n a l performance. I t  that  certain  conditions,  i n C h a p t e r I V , must be met  investment  paragraph  i s to r e f l e c t  i f the r a t e  the.performance  In describing- Armstrong J . Muth s t r e s s e s  Cork  of a Company  the importance  independence:  The company i s d e c e n t r a l i z e d t o t h e 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  of  of  84 d i v i s i o n a l investment i s delegated to the d i v i s i o n a l manager. The d i v i s i o n a l m a n a g e r d i r e c t s t h e p r o d u c t i o n and d i s t r i b u t i o n o f t h e 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 a n d does n o t e x p e c t i n t e r f e r e n c e f r o m t o p management b e y o n d t h e p o i n t o f 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 a n d . s a l e s m a t t e r s u n l e s s t h e y 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 . This proper delegation 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 t o p management g r o u p s t o a c h i e v e , b u t i t i s a 'must' u n d e r t h e 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  If evaluating allowance ioned  this  i s n o t done, t h e n t h e t o p management i s  itself.  In appraising divisional  must be made f o r u n c o n t r o l l a b l e  before, these over which  thereby  obscure e v a l u a t i o n .  should  measure.  related  the d i v i s i o n a l  Past  s e r v e as g u i d e s  managers.  ;  as ment-  intertwined with  t h e d i v i s i o n manager h a s c o n t r o l a n d  Of. n e c e s s i t y , relative  factors;  are o f t e n i n e x t r i c a b l y  factors  performance,  experience i n setting  To be e f f e c t i v e ,  s t a n d a r d must be a  a n d company standards  standards  t o some k i n d o f a n i n c e n t i v e  expectations  for division  must be known a n d system.  1 " F r e d e r i c k J . Muth, " R e t u r n o n I n v e s t m e n t — Tool of M o d e r n Management," I m p r o v e d T o o l s o f F i n a n c i a l Management (New Y o r k : A m e r i c a n 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 , 1 9 5 6 ) , p p . 8-9.  85 CHAPTER V I I I  SPECIAL:,PROBLEMS OP ON  In not  INVESTMENT  of the r a t e of rate  ing . d i v i s i o n a l  performance,  o f r e t u r n on  I  division  on  of  s y s t e m s w h i c h c a n be  p r i c e may  be ' n e g o t i a t e d  on m a r k e t ,  •investment,  investment  TRANSFER  investment  in  appraistransfer  decisions  PRICES  and  transfer  i t i s important  i s used,  pelled  t o use  of return  used by  products  that  value  result.  There  are a  d i v i s i o n managers,  plus  a percentage  of a l l these methods.  a n y method- w h i c h w i l l  detrimentally  The  i t may  return  t h e d i v i s i o n a l manager s h o u l d n o t  on  number  t o e s t a b l i s h the p r i c e .  the  o r on c o s t  be  on Whatever  be  com-  affect his  investment.  From the p o i n t t r a n s f e r s that  the p r o f i t  will  o r a. c o m b i n a t i o n  method  only  investment  problems,  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 , otherwise d i s t o r t i o n  d i v i s i o n a l performance  rate  The  the  When d i v i s i o n s , a r e e v a l u a t e d  to another,  of  based  and  ESTABLISHMENT OP  of the r e t u r n  a d d e d be  u p o n and  level.  General background.  one  problems  namely, e s t a b l i s h m e n t o f  l e a s i n g of f a c i l i t i e s ,  made a t d i v i s i o n  from  some o f t h e  o f r e t u r n summarized.  c o n c e r n the use  terms  RETURN  i n previous chapters are touched  limitations  in  RATE OP  the f o l l o w i n g paragraphs  covered  prices,  THE  of maximizing  company's p r o f i t ,  s h o u l d be made a r e t h o s e ' w h i c h  o f t h e company.  The  the  increase  d i v i s i o n manager.should  not  8 6  be  able to.increase his profit  profitability.  One  division  expense of a n o t h e r . good b u s i n e s s ;  and  a u t h o r i t a r i a n and  into  should not  be  overall  favoured  provide  The  profits,  and  divisional  efforts  objectives should  the  interests  at  the  the  d i v i s i o n m a n a g e r ' s autonomy must  terms-of  otherwise  the  t h e b e s t way  transfer  to achieve  between d i v i s i o n s  and  ing p r i n c i p l e s :  company as  evaluation of"his  t h e r a t e o f r e t u r n on Negotiated  of the  divert  identical with  preserved,  the  the  is  arbitrary  be  same t i m e ,  the  a poor b a s i s f o r a p p r a i s i n g  obscure  channels.  at  discrimination  s u c h m e a s u r e s a r e b o u n d - t o be  performance,  uneconomic  expense o f  Intra-company p r i c e  not  divisional  a t the  investment  prices. identity  a whole;  performance loses  be in  significance.  J o e l Dean f e e l s  that  o f p u r p o s e and o b j e c t i v e s  company i s t o a d h e r e  to the f o l l o w -  -  (1) P r i c e s o f a l l t r a n s f e r s i n and out o f a p r o f i t c e n t e r s h o u l d be d e t e r m i n e d b y n e g o t i a t i o n b e t w e e n b u y e r s 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 a c c e s s t o f u l l . d a t a o n a l t e r n a t i v e s o u r c e s and m a r k e t s and t o 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) B u y e r s a n d s e l l e r s s h o u l d be t o • d e a l o u t s i d e t h e company.*  Under t h e s e  c o n d i t i o n s t o p management c a n  a u t h o r i t y t o d i v i s i o n managers w i t h o u t the  completely  d i v i s i o n managers' p r o f i t  goals are  undue f e a r the  free  delegate because  same a s  those  of  1 J o e l Dean, " D e c e n t r a l i z a t i o n a n d I n t r a - c o m p a n y P r i c i n g , " H a r v a r d B u s i n e s s Review, 'July-August, 1 9 5 5 , p.  6 8 .  87 the  t o p management.  higher  p r i c e s *than t h e  not  sell  its  own  of  the  The  buying  m a r k e t , and  f o r l e s s than the profits,  entire  the  division will the  market.  not  selling  be,  in practice, difficult to p u b l i c  is  always a v a i l a b l e .  obtained, in  the  inside may  be  of  concentrating  may  prove  top  on  same, as  accept.  the  by  unprofitable  i n the  future.  and  Transfers  the  prices of  the  cost.  of  advisable.  economic  Transfers  may,  advantages  promise  such d i v i s i o n s  survival for and  Nevertheless,  at  is likely  the  d i r e c t i o n from  advantage of  t o agreement; f r i c t i o n  again  Some d i v i s i o n s  c r e a t i n g a g r e e m e n t among  at  here than  long-run  moment, b u t  some i n t e r f e r e n c e be  draw-  d i v i s i o n managers  E l i m i n a t i o n of prospects  traded  This  But  be  emerging  being  rather  results.  at  prices  prevail.  foregoing  o v e r p r i c e s have the  arbitrariness  ability  The  prices could  negotiations.  short-term  management may  conducive  the  s e l f i s h n e s s of  Therefore,  otiations  and  even i f market  bargaining  r e s u l t i n i n j u r i n g the  company. the  t o be  rewards  profits  about- m a r k e t  transfers, instead  short-sighted  and  may  implement  a transaction that w i l l  Unfettered  rich  But be  to  information  i s r e m e d i e d by  the* s k i l l e d  t i m e s , be  maximize  proposition  company., were t h r o w n o n .the m a r k e t .  feasibility  at  private  c a s e where l a r g e  back, however, it  and  t h e y would not  the  will  company.  access not  to  a l s o maximize the  A l t h o u g h t h e o r e t i c a l l y s o u n d , Dean's may  at  division  In.seeking  division will  buy  neg-  avoiding executives.  cost to  are  not  develop  between  88 d i v i s i o n a l managers u s i n g pricing.  The  difficult  to  of  The  complex  word  are  be  cost  at  line,  at  the on  an  "cost",  i d e a s . ' 'For  several products at costs  in.intra-company  method sounds s i m p l e , implement w i t h o u t  from above. set  costs  i t be  at  on  the  a l l products  or  a  or  an  ?  Should  o v e r h e a d be  try  to  answer a l l t h e s e q u e s t i o n s .  the  requirements  of  There are  the  standard or  rate  various  Should  cost,  not  ?.  This  No  of r e t u r n  degrees of  on  i s which  the  transfers  high-cost cost-plus a c t u a l cost  paper w i l l  one  succession,  t r a n s f e r s at  to  the  by  the. d i v i s i o n  inside selling  division  selling  i n g management may  to  cost- m e t h o d m e e t s investment  measure.  arbitrariness in a l l  worked on  by the  the  low  the  cost  plus  the  difficulties  at  provide  a l l the  outside  cost  of  on  plus  of  one  added.  products  profit  i s taken Also  up  operat-  i n methods division  or are  divisions that  stages.  a-return  investment  transfers at  any  profit  market.  inefficiencies  in earlier  a return  some more p r o b l e m s  not  c o s t - o f more e f f i c i e n t  product  Transfers  the  —  do  o v e r l o o k p r o f i t a b l e changes  product flows because the c o v e r e d up  cost  ?  not  c o s t methods... I n a d d i t i o n , when many. d i v i s i o n s h a n d l e in  a  producing  question  cost  figure  included  the  to use.  line,  of  at  stands f o r  example,.in a d i v i s i o n  low-cost  Should  extremely  some a u t h o r i t a r i a n d i r e c t i o n  different costs,  average cost  i t is  though simple,  most a p p r o p r i a t e the  hut  transfer  cost  on  investment.  In  transfer pricing a l l are  also present,  with  89 It of r e t u r n with  on  that  the  the  find may  i f there  than t h e i r  profit  plus  by  on  the  method  on  prices, a rate  on  inadequate  If  the  in  comparison w i t h  itarian. investment  to  are  This  of  the  cost  impact market.  plus  i n v e s t m e n t m e t h o d , h a v e a number o f  dis-  than t r a n s f e r s at  m a r k e t p r i c e s may  outside  intra-company  permitted, the  i n performance  negotiated  The  cost  not  or  be  the  j u s t nominal p r i c e  quality, timing,  and,  external  whole  cost  limits  disadvantages  a  at  ,.: C o n c l u s i o n . petitively  less  company as  Transfers  and the  the  utility  quotations  company i s the  i f dealings  the  rate  products.  smaller market  with  t r a n s f e r s become of  best  l o c a t i o n of  transactions,  alternative.. Also, not  the  t r a n s f e r s , might  weaknesses of the  to  market  of goods t r a d e d  offer a real  s i d e market  The  of  at  Published  or  not  i n terms  arbitrary.  b e c a u s e t h e y m i g h t be  flow  think  method  that would b r i n g  at market p r i c e s .  though b e t t e r  as  of  even though the  sales.  i s b o u n d t o be  advantages. guide,  t o make s a l e s  costs,  this  various  However, d i v i s i o n s n e a r e s t  d i v i s i o n w h i c h deals w i t h  of r e t u r n  to  of  i n v e s t m e n t method c u m u l a t e ; t h e i r  Transfers  rate  purchased at  main advantage  i s a succession  increased  a return  falls  The  investment.  i t unprofitable  revenue  i . e . , assets  d i v i s i o n manager i s f o r c e d  market,  the  e s p e c i a l l y , i n the. case of d i v i s i o n s  price levels.  r e t u r n on  final  The  investment,  d i v i s i o n s to.-agree o n  a d i f f e r e n t asset.mix,  t i m e s and is  i s h a r d f o r the  does  out-  author-  of r e t u r n  on  evaluation.  conclusion  seems t o  t r a n s f e r p r i c e s have the therefore,  are  the  best.  be  that  com-  l e a s t number The  compet-  . 9 0 itively of  negotiated  operating  economic  transfer pricing  divisions  and p r e s e n t s  performance.  divisions  The  the  best  and  the promotion of mutual  outside  profit  to  encourages  there  i s a market  c a n be  prices  price  i n the making II.  Divisional and l e a s i n g  leads,  as  'On-the o t h e r only  hand,  i f market  this  may  for  the. company as a w h o l e . of return  included  result  a  FACILITIES be  i m p r o v e d by  i n a lower r a t e  This  i s higher  i n the r e n t ,  of c a p i t a l  are  h i d d e n and.may h a v e  u s e d by t h e d i v i s i o n ,  same.time,  cost  or not.  irrespective  transfer prices  p e r f o r m a n c e may  the f a c i l i t i e s  rate  can be.used  of managerial decisions.  L E A S I N G OF  the  company's  interests  negotiation;  obtained.  T h e y k e e p many l o s s e s  value  and p r o f i t  hard-headed  c a n be u t i l i z e d  O t h e r methods f o r s e t t i n g  inadequate.  ision's  C o m p e t i t i o n t o make  economic  transfer' p r i c e s  a t market  quotations  negative  purchas-  co-operation.  whether  transfers  t h e company.  showing  Negotiated  ... .  unprofitable  b y means o f d i v i s i o n b u y e r s and. s e l l e r s  or s e l l i n g  of  independence  a m e a n i n g f u l measure o f  system e l i m i n a t e s  ing  always,  preserves  selling but, at  of  return  can happen i f the than the l e s s o r ' s  divinterest  b u t , a t t h e same t i m e , t h e  i s lower than the l e s s o r ' s  capital  charges.  Under  t h e s e c i r c u m s t a n c e s , t h e manager c a n  improve  91 his return  on  by  percentage  greater  point is  investment  of view, t h i s  lower t h a n the  The investment the  of  "from t h e  than his  the  can  be  leased  The  level,  be  partially  solved  of  by  capital  c o n t r i b u t i o n income.*  expect  that  leasing,  top  If than the the  may  divisional rate  d i v i s i o n s may per  cent,  vestment; these r a t e s able ision  rates  '  1  the  capit-  division's  source  of  charging"divisions and  evaluating  separated  capital, The  30  per  operating  with  the i n terms?  however,  not  DIVISION  to of  on  contemplated  make t h e  other  30  various rate  LEVEL  r a t e . of.'return i s  per  of r e t u r n w i l l  cent  and  problem  performance  serve  return  on  as.minimum  investments.  of r e t u r n ,  invest. .  of r e t u r n ;  cent  any  higher  investment,  d e c i s i o n to  have d i f f e r e n t r a t e s the  on  leases.  of r e t u r n  i n considering  earning  including a  management w i l l want t o r e t a i n c o n t r o l  projected  h a v e 20  capital  repeals.  I t . seems r e a s o n a b l e ,  d i v i s i o n manager w i l l  Various  of  company's c r e d i t .  .INVESTMENT. DECISIONS AT  the  company's  o p e r a t i n g . a c t i v i t i e s are  e s p e c i a l l y o f major  Ill  base  a r i s e s , mainly, because  f i n a n c i a l management, i . e . : ,  company's c o s t of  in  facilities,in  conflict the  investment  i t s cost  a v o i d e d by  because l e a s i n g a f f e c t s the can  his  income., From the  i n t e r e s t charged  base.  divisional  reducing  is unprofitable;  conflict  a l i z e d value  by  For  a  one inacceptdiv-  investment  '  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 R o t c h , " R e t u r n on I n v e s t m e n t as a M e a s u r e o f P e r f o r m a n c e " ( U n p u b l i s h e d ' , 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 rate  be r e j e c t e d . rate  Similarly  of return  investment and w i l l ,  of return  will  —  is, lower  therefore,  the o v e r a l l not.be  o f 1 9 p e r cent on  divisional  accepted.  o f , say, 23 per cent  division  is likely  with the c u t - o f f rate  rate  with  problem  is-more  investments rejected  solved the  conflict results between d i v i s i o n s  of the d i v i s i o n .  division  total  division;  are l i k e l y  t o be  differences  a n d t h e company.  i n the cost The r a t e o f  constitutes the cost  The c o n f l i c t  of  c a n be p a r t i a l l y  decisions  contemplated  by  manager o r b y c h a r g i n g t h e d i v i s i o n w i t h t h e  cost  investment.. ceases  from  by r e v i e w i n g investment  company's by  w i t h a. h i g h r e t u r n  o n . d i v i s i o n a l investment  capital  management.  by i t .  capital  return  the expected  o f 20 p e r cent, but i ti s  a c c e p t a b l e t o t h e company  The of  serious  rate  t o be a c c e p t e d b y t h e  p r o b a b l y n o t g o i n g t o be a c c e p t e d b y t h e . t o p The  new  of return  I f t h e company's  o f r e t u r n , i s 2 5 p e r c e n t , , a new. i n v e s t m e n t return  will  with a d i v i s i o n , earning 20 p e r cent  the expected r e t u r n lower  than 30 per cent  of c a p i t a l  based  o n the. d i v i s i o n a l  I n the l a t t e r case,  income a f t e r  t o be a r a t e  total  the p e r f o r m a n c e . i s measured  the i n t e r e s t  charge.  This,  however,  o f r e t u r n on investment measure.  LIMITATIONS OP THE RATE OP RETURN ON IN EVALUATING  Managerial performance Some o f them were e n u m e r a t e d  INVESTMENT  PERFORMANCE  i s the r e s u l t  in  Chapter  I.  o f many f a c t o r s . Income  was  93 •assumed t o be rate  the primary g o a l of business a c t i v i t y  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  performance  in profit  performance  i n terms  t e r m s , may  not r e f l e c t  o f the achievement  and  the  managerial  managerial  of other business  objectives. But measured of a l l ,  even the achievement  i d e a l l y by t h e r a t e though  advanced,  theoretical Existence  goal  o f r e t u r n on  definition  m e a s u r e m e n t o f income  proposition.  of p r o f i t  i s not  investment.  o f i n c o m e may  i n practice  of a m u l t i p l i c i t y  i s an  First  be  immense  of accounting  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 ,  to  Secondly, d e f i n i t i o n  the magnitude  investment account and,  base  life  also,  because  important i n t h i s  property  levels.  and a l s o  Divisions  asset  comparable  into  comparisons  Indexes  level  revenue  asset  investment base  division.  of long-  substantially  w i t h an o l d e r  for a single  of p r i c e  at  than  This  mix younger  introd-  comparison between d i v i s i o n s  are s i m i l a r l y  v a l u e s and size,  cost  acquired  on  assets.  of i n f l a t i o n ,  lower d e p r e c i a t i o n charges.  some d i s t o r t i o n s  between companies  state  a period  i s a mixture of assets  price  interperiod  of v a l u a t i o n of  and  c o n n e c t i o n i s the problem  After  have a l o w e r h i s t o r i c a l  divisions uces  of the problem  of the  mainly,  of i d e a l matching of cost  level fluctuations.  different will  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 ,  of impossibility  Very price  of the problem.  testifies  and  Comparisons  distorted.  changes  c a n be u s e d  d e p r e c i a t i o n charges  but the v a l u e of t h i s  step  to r e -  i n dollars  of  i s open to  question.  94 I t was to  suggested  a c e r t a i n extent,  standards  that  this  p r o b l e m c a n be  by a d j u s t i n g m a n a g e r i a l  performance  t o 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  changes  into account.  This  involves  lessens  the usefulness  of evaluation  avoided,  price  judgment and,  level  therefore,  i n terms o f t h e r a t e o f  return.  The An i d e a l  question  standard  investment  should  of standards  must p o i n t  is crucial  t o what a r a t e  of return  be u n d e r c e r t a i n c o n d i t i o n s .  u s e d a t t h e « p r e s e n t . t i m e are., m a i n l y , history;  and p a s t  possible  performance that  management s h o u l d  i n evaluations.  performance follow.  on  Standards  a review of past  i s not n e c e s s a r i l y the best  both the top and.the  division  95  CHAPTER I Z CONCLUSIONS OP THE STUDY The  p r i m a r y p u r p o s e . o f t h e r a t e o f r e t u r n on  i n v e s t m e n t i s to, g u i d e d i v i s i o n a l managers i n t h e i r p e r f o r m ance and t o h e l p t o p management i n e v a l u a t i n g i t s own and the  divisional-performance.  I n e v a l u a t i n g p e r f o r m a n c e , t h e t o p management must c o n s i d e r and d i s t i n g u i s h between t h e p e r f o r m a n c e o v e r w h i c h 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 t o o t h e r u n c o n t r o l l a b l e f a c t o r s . N e x t , t h e t o p management must e s t a b l i s h standards. These a r e , u s u a l l y , d e t e r m i n e d by comp a r i s o n s . w i t h o t h e r companies and d i v i s i o n s i n t h e same i n d u s t r y . The s t a n d a r d s must be c o n s i d e r e d o n l y as g u i d e p o s t s and n o t as some immutable t r u t h s . M a n a g e r i a l judgment must always be u s e d . P e r f o r m a n c e s t a n d a r d s must be made known t o t h o s e c o n c e r n e d so t h a t t h e y know what t o m a x i m i z e . Despite chapter,  the l i m i t a t i o n s l i s t e d  i n the preceding  t h e r a t e o f r e t u r n on i n v e s t m e n t i s c o n s i d e r e d  a u s e f u l method i n e v a l u a t i n g m a n a g e r i a l p e r f o r m a n c e .  to.be I t does  not e l i m i n a t e judgment c o m p l e t e l y . f r o m e v a l u a t i o n , b u t i t does l i m i t t h e a r e a o f 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 anything  t h a t has been u s e d h i t h e r t o .  I n a d d i t i o n t o income and' s a l e s , t h e r a t e o f r e t u r n measure includes investment.  I t measures t h e e f f e c t i v e n e s s w i t h w h i c h  96 management h a n d l e d points The  to.the  the  resources  a r e a s where t h e  psychological  influence  entrusted  performance  of  the  rate  to  i t s care  can  he  and  improved.  of r e t u r n  on  invest-  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  incentives,  should  improved  not  he  overlooked  as  i t may  r e s u l t i n an  performance. • ®n can  be  the  used  company l e v e l ,  i n evaluating  lable, influences  are  divisional level, flect  i . e . , the  return  divisional  measured, r e a l i s t i c  Generally, of r e t u r n  on  s i t u a t i o n and born  return  revealing research  does not  figure;  rate  of performance.  i s not  neither area  are  the  It  set,  be  marked  profits  that in  the  rate  evaluateach  method s h o u l d the  rate  always  of  single all-purpose, a l l figure.  i s n e c e s s a r y t h a n has investment  Par  b e e n done  a reliable  e n t i r e l y wrong f o r  e n t e r p r i s e which  i n a complex w o r l d ,  What  measure  the  can'  is right for  another.  is a  more  hitherto  whether-a-single f i g u r e  managerial problems.  In a business organism operating  i n the  are  etc.  seems t o be  is i t a precise  is doubtful  re-  properly  contribution  remembered t h a t  o f r e t u r n on  e v e r answer a l l the p u r p o s e may  adequately  i s a good measure t o use  I t must be  investment  t o make t h e  standards  conclusion  the  certain conditions  boundaries  l i m i t a t i o n s inherent  i n this  uncontrol-  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  i n mind. on  the  investment  i n g performance ;  one  of  on' i n v e s t m e n t  f r o m p e r f o r m a n c e . . On  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 ,  properly  be  rate  of r e t u r n  management, p r o v i d e d  eliminated  the  rate  managerial performance, unless  fulfilled, off,  top  the  complicated executives'  •  .  97  s e a r c h f o r a magic f o r m u l a w h i c h e l i m i n a t e s judgment he  doomed t o  The  failure.  r a t e 'Of r e t u r n o n  t o u n d e r s t a n d , has and  discussed i n this  paper.  and  imate  i t has  measure, hut i n c l u s i o n and  the  N e v e r t h e l e s s , the r a t e  several  I t i s an  important  investment,  i t c a n he  produced.  and  d e c i s i o n s on  Information a v a i l a b l e .  of eval-  approx—  important income, and ( 2 )  These a r e o f g r e a t  s i g n i f i c a n c e - t o management whose f u n c t i o n a n d making i r r e v e r s i b l e  in  out  advantages  c o n s i d e r a t i o n o f t h e most  w i t h which  simple  t h e s e were p o i n t e d  decisionmaking.  i n "business, s a l e s ,  speed  although  o f g r e a t h e l p to.management  u a t i n g performance  figures  investment,  i t s limitations;  r e t u r n m e a s u r e c a n he  (1)  must  a r t must  the b a s i s of the  best  remain  BIBLIOGRAPHY  99 BIBLIOGRAPHY I BOOKS. 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" P r o f i t a b i l i t y Indexes f o r C a p i t a l I n v e s t m e n t , " The- C o n t r o l l e r , F e b r u a r y , 1958. - . Edson, H a r v e y 0. " R e t u r n on Investment (ROI) as a Measure o f Management E f f i c i e n c y , " The C o n t r o l l e r , J u n e , 1957. • . . " S e t t i n g a S t a n d a r d f o r y o u r Company's R e t u r n on I n v e s t m e n t , " The C o n t r o l l e r , September, 1958. Evans, M.K.' " A c c o u n t i n g Problems i n M e a s u r i n g P e r f o r m a n c e by O r g a n i z a t i o n a l U n i t s , " N . A . C . A . B u l l e t i n , A u g u s t , 1955. Freeman, E. S t e w a r t . " M e a s u r i n g S a l e s , Gross A s s e t s and I n v e s t e d C a p i t a l and Comparing them t o P r o f i t s , " The C o n t r o l l e r , F e b r u a r y , 1955* Heinaman, S t e p h e n T. " R e t u r n on I n v e s t m e n t : • Approach t o I n v e n t o r y , " 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. " P r e s s u r e on P r o f i t s , " • Fortune., November, 1957.- K e l l e r , I . Wayne. "The R e t u r n on C a p i t a l Concept," • N.A.A. B u l l e t i n , M a r c h , 1958. Kutvirt, 0taker. Investment,"  " D e p a r t m e n t a l i z a t i o n o f R e t u r n on N.A.C.A. B u l l e t i n , - A p r i l , 1959.  Lammie, H.R. " R e t u r n on C a p i t a l Employed," A c c o u n t i n g , . A u g u s t , 1958.  Journal of  . " R e t u r n o n C a p i t a l Employed as a Y a r d s t i c k f o r Appraisal," N.A.A. B u l l e t i n , November, 1959. L i n d s e y , D a v i d H.- "Two Problems i n A n a l y s i s o f R e t u r n on I n v e s t m e n t , " . N.A.C.A. B u l l e t i n , F e b r u a r y , 1956., May,  George 0. "Concepts o f B u s i n e s s Income and T h e i r I m p l e m e n t a t i o n , " The Q u a r t e r l y . J o u r n a l o f Economics, : F e b r u a r y , ' 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 Subd i v i s i o n s o f a. Company," N.A.A. B u l l e t i n , September, 1957.  M o l l e r , „G. " T r y B u d g e t i n g • f o r R e t u r n on C a p i t a l Employed," The C o n t r o l l e r , M a r c h , 1958. . . . . . " M e a s u r i n g Management P e r f o r m a n c e , " Management (Canada), M a r c h , 1958.  Cost, and  Muth, F r e d J . •"Return on C a p i t a l Employed — Measure o f Management," N.A.C.A. B u l l e t i n , " F e b r u a r y , 1954. . . -"Measurement o f R e t u r n on C a p i t a l Employed b y ' P r o f i t C e n t e r s , " C o s t and Management (Canada), J a n u a r y , 1957.. » P a t t o n , A r c h . "How t o A p p r a i s e E x e c u t i v e P e r f o r m a n c e , " H a r v a r d B u s i n e s s Review, J a n u a r y - F e b r u a r y , I 9 6 0 .  Pepke,.Walter.  103 " P r o f i t Package,",Porbes, October-1, 1958.  Read, Russel B. "Return on Investment -- A Guide to. Management Decisions," N.A.C.A. B u l l e t i n , June, 1954. Return on C a p i t a l 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. B u l l e t i n , February, 1954. Rushton, James H. " P r i c i n g to Maximize Return on Investment," The C o n t r o l l e r , March, 1955. Seed, A l l a n H. "Capital Turnover-— Key to C a p i t a l Management,", N.A.A. B u l l e t i n , June, 1958. Sheehan, Daniel W. "Relation of Invested C a p i t a l to P r o f i t , " The C o n t r o l l e r , October, 1956. ;  Shillinglaw,.Gordon. "Guides to I n t e r n a l P r o f i t Measurement," Harvard Business Review, March - A p r i l , 1957. Some V a r i a t i o n i n Construction and Use of Return on Investment. Based on N.A.A. Technical Service Accounting Procedure Survey No. 1648,. N.A.A. B u l l e t i n , March, 1958. Strong, W.L. "Decentralized Operation, A Control Program," The. C o n t r o l l e r , January, 1958. Vatter, William J . "Does the Rate of Return Measure Business E f f i c i e n c y ?" N.A.A. B u l l e t i n , January,.1959. . V i l l e r s , Raymond. "Control and Freedom i n a Decentralized Company," Harvard Business Review, March - A p r i l , 1954. Wright, John W.D. "Setting Earnings Standards f o r Decentralized Operation,"- The C o n t r o l l e r , February, 1957.  104 IV STATISTICAL  Moody's I n d u s t r i a l M a n u a l ,  PUBLICATIONS  J o h n Moody, 1959.  N a t i o n a l A c c o u n t Income and E x p e n d i t u r e , 1926-1956. Dominion B u r e a u o f S t a t i s t i c s , 1958? pp. 26-27. S u r v e y of.. Current, B u s i n e s s : 1957 B u s i n e s s Supplement, p.. 3.  Statistics  The F o r t u n e 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 C o r p o r a t i o n s , F o r t u n e , J u l y , -1959, p.126.  A P P E N D I X  106" APPENDIX Three companies  i n e a c h o f t h e two  industries  a r e compared  investment  on t h e i n t r a - i n d u s t r y  ' The  industries  i n terms  of the r a t e  (2)  Paper  and P u l p  Industry.  o f i n c o m e and  a r e as a d v a n c e d  before interest  ment  i s defined  iation  as  investment used  i n this  on f u n d e d the t o t a l  a l l o w a n c e s and  POP investment  on  and  paper.  as t h e n e t i n c o m e o f t h e company, w h e t h e r but  of return  chosen a r e :  Integrated O i l Industry,  comparisons  Canadian  basis.  (.1.)  Definitions  chosen  d e b t and assets  i n the  Income i s d e f i n e d recurring  or not,  income t a x e s .  available  after  Investdeprec-  other valuation accounts.  the purpose  of comparison,  a t t h e b e g i n n i n g and  the average  of the  a t t h e end o f t h e p e r i o d i s  taken.  The assets rate  figures  for.net  a r e shown i n t h o u s a n d s .  of return figures  the p e r c e n t on s a l e s The return  on  companies  S  a  l  The  to  e  and  and  average  Small discrepancies  arise-due  i n the  to the r o u n d i n g o f f of  turnover r a t i o .  a r e a n a l y z e d i n terms  -  of the r a t e  Sales  =  Investment  s  principal  o f r e t u r n on  financial  may  n e t income,  of  investment formula:  Income .  rates  sales,  s o u r c e s ' o f data used  investment i n t h i s  s t a t e m e n t s o f the companies  p  e  Q  r  n  t  i  n  v  i n computing  a p p e n d i x were in their  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 .  e  s  r  e  t  t  m  e  u  n  r  t  the  published  annual  reports  n  107  I  ANALYSIS OF RATES OF RETURN ON INVESTMENT I N PETROLEUM, PRODUCING, REFINING, TRANSPORTING, AND DISTRIBUTING COMPANIES The f o l l o w i n g companies a r e a n a l y z e d i n terms o f t h e  r a t e on i n v e s t m e n t f o r m u l a : (1 ) (2) (3)  C a n a d i a n O i l Companies L i m i t e d Texaco Canada L i m i t e d 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 .  T a b l e V I I I , page 1 1 0 , T a b l e I Z , page 1 1 1 , and T a b l e Z, page 1 1 2 , a n a l y z e t h e performance o f companies o v e r t i m e , f o r the p e r i o d o f f i v e y e a r s f r o m 19.54 t o 1 9 5 8 i n c l u s i v e . Table Z l , page 1 1 3 , compares i n t e r - c o m p a n y performance f o r 1 9 5 8 . Canadian O i l Companies.Limited.  The performance o f  C a n a d i a n O i l Companies L i m i t e d , as shown i n T a b l e V I I I , page 110,  i s d e c l i n i n g i n terms o f t h e r a t e o"f r e t u r n o n i n v e s t m e n t .  The f l u c t u a t i n g income, as a p e r c e n t o f s a l e s , and t h e 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 p e r c e n t o f s a l e s , i n c r e a s e d f r o m 8 . 3 8 p e r c e n t i n 1954 to. 1 1 . 2 2 p e r c e n t i n 1956 and dropped t o 7 . 8 5 p e r c e n t i n 1958.  On t h e o t h e r hand, t h e t u r n o v e r r a t i o d e c l i n e d f r o m  . 9 4 i n 1954 t o .76 i n 1 9 5 8 .  As a consequence., . t h e r e t u r n on  investment decreased from 7 . 8 8 p e r cent i n 1954 t o 5 . 9 7 p e r cent i n 1 9 5 8 . Comparison w i t h c o m p e t i t i o n , T a b l e X I on page 1 1 3 , shows t h a t t h e company's performance  c a n be improved by i n -  c r e a s i n g t h e a s s e t t u r n o v e r , 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 resources,  and  an i n c r e a s e  i n sales  margin. •Texaco Canada L i m i t e d . The 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 on i n v e s t m e n t o f Texaco Canada L i m i t e d i s shown i n T a b l e I X , page 111. The company's r a t e o f 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 t h e company's income as a p e r c e n t o f s a l e s ; t h e d e c l i n e i s f r o m 14.73 p e r c e n t i n 1954 t o 9.88 p e r c e n t i n 1958. The company's t u r n o v e r r a t i o a l s o dropped i n the same p e r i o d - f r o m 1.13 i n 1954 t o 1.09 i n 1958. N e v e r t h e l e s s , o f t h e t h r e e 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 r a n k s f i r s t i n terras o f the r a t e of r e t u r n f o r m u l a : income as a p e r c e n t of s a l e s and t u r n o v e r (See T a b l e X I , page 113.) T h i s a c c o u n t s f o r t h e company's h i g h e r r e t u r n on i n v e s t m e n t t h a n i n the c a s e o f the o t h e r two companies. However, measures must be t a k e n t o a r r e s t and r e v e r s e t h e downward t r e n d i n the r a t e of r e t u r n o n . i n v e s t m e n t . D e t a i l e d s t u d y o f 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 A m e r i c a n O i l Company L i m i t e d . T a b l e X, page 112,  As shown i n  the p e r f o r m a n c e o f 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 i s c h a r a c t e r i z e d by r a p i d l y d e c r e a s i n g o f income t o s a l e s and  turnover  t h r e e companies c o n s i d e r e d L i m i t e d presents  I n . f a c t , of  the  h e r e , B r i t i s h A m e r i c a n O i l Company  the poorest p i c t u r e of performance.  T a b l e X I , page 113.) s a l e s and  of a s s e t s .  ratio;.-  (See  Improvements i n b o t h r a t i o s , income t o  s a l e s t o a s s e t s , a r e needed t o b r i n g the company  t o p a r w i t h the o t h e r two  companies.  109 Conclusions. specific at  More  characteristics  sound c o n c l u s i o n s  that a  the three  fore,  i n order  the i n d i v i d u a l  VIII,  I X , a n d X,  companies a r e f a c e d w i t h  declining rate  i s needed  o f e a c h company  about  Examination of Tables,  information  company  about to a r r i v e performance.  however,indicates t h e same p r o b l e m , i . e . ,  o f r e t u r n on investment.  I t may  be,  there-  t h a t some e x t e r n a l a n d u n c o n t r o l l a b l e f o r c e s a r e a t  work i n . a l l  three  however, i s beyond  cases.  The s t u d y  the scope o f t h i s  of external forces, paper.  1  110  TABLE V I I I RATE OP RETURN ANALYSIS CANADIAN O I L COMPANIES L I M I T E D  Year  Net sales  1954 1955 1956 195.7 1958-  58,518 66,197 76,171 84,318 85,928  ($000)  Net income  ($000)  4,906  6,273 8,554 8,379 6,748  Average" assets  ($000)  Income a s a per cent of sales  62,479 • 8.38 9.47 76,869 11.22 95,720 104,731 9.93 113,695 7.85  Turnover  .94 .86 .80 .80 .76  Per cent r e t u r n on • investment  7.88 8.14 9.98 7.94 5.97  111  TABLE I Z RATE OF RETURN ANALYSIS TEZAGO CANADA LIMITED  Year  Net •sales ($000)  1954 1955 1956 1957 1058  101*275 115,121 142,874 18.3,467 17.5,308  Net • income ($000)  Average assets ($000)  14,921 89,411 18,114 95,615 24,226 12.2,745 2.6,416 154,010 17,336 161,342  Income as a p e r cent of s a l e s 14.73 ,15.73 16.95 14.39 . 9.88  Turnover 1.13 1.20 1.16 1.19 1.09  Per cent r e t u r n on investment 16.64 18.88 19.66 17.12  10.77  112  TABLE Z. RATE OP RETURN ANALYSIS BRITISH AMERICAN OIL COMPANY.LIMITED  Year 1954 1955 1956 1957 1958  Net sales ($000)  Net income ($000)  242,713 3 0 , 0 9 5 268,556 34,479 278,049 ; 31,068 3 0 8 , 2 9 0 35,759 318,502 24,381  Average assets ($000) 231,840 253,346 321,253 402,872 469,087  Income as a per cent of s a l e s 12.39 12.83 11*. 17 11'.59' 7.65  Turnover 1.05 1.06 .86 .76 .68  Per cent r e t u r n on investment 13.01 13-. 60 9.61 8'.8l 5.20  113  TABLE X I RATE OP RETURN ANALYSIS . INTER-COMPANY COMPARISON.OF RATES OF RETURN ON INVESTMENT FOR 1958  Company  Income as a p e r cent o f sales  Turnover  Per cent r e t u r n on investment  Texaco Canada L t d . , (Table IX)  9.88  1.09  Canadian O i l Companies L t d . , (Table V I I I )  7.85  .76  5.97  B r i t i s h American O i l Company L t d . , (Table X)  7.65  .68  5.20  10.77  114 I I ANALYSIS OF RATES OF RETURN ON INVESTMENT IN PAPER AND PULP COMPANIES The a n a l y s i s o f t h e r a t e s o f r e t u r n on i n v e s t m e n t i s made i n t h e f o l l o w i n g t h r e e companies: (1) A b i t i b i Power and P a p e r Company L i m i t e d * (2) , S t Lawrence C o r p o r a t i o n L i m i t e d (3) A n g l o - C a n a d i a n P u l p and P a p e r M i l l s L i m i t e d . T a b l e s X I I , page 117, X I I I ,  page 118, and XIV, page  119 , a n a l y z e t h e p e r f o r m a n c e o f t h e t h r e e companies f o r t h e p e r i o d f r o m 1954 t o 1958 i n c l u s i v e . compares  T a b l e XV, page 120,  i n t e r - c o m p a n y p e r f o r m a n c e f o r 1958. A b i t i b i Power a nd P a p e r Company L i m i t e d . r  page 117, shows t h a t the,company's  Table X I I ,  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 , b o t h i n terms o f income,.as a p e r c e n t o f s a l e s , and t u r n o v e r r a t i o . As a consequence, t h e r e t u r n on i n v e s t m e n t dropped f r o m per  18.48  c e n t i n 1956 t o 14.43 p e r c e n t i n 1957 and t o a l o w o f  11.70 p e r c e n t i n 1958.  I t seems t h a t b o t h n e t s a l e s and n e t  income d i d n o t keep up pace w i t h t h e a s s e t e x p a n s i o n . T a b l e XV, page 120, however, shows t h a t t h e company t a k e s t h e f i r s t p l a c e i n income, as a p e r c e n t o f s a l e s ^ and the  second p l a c e i n t u r n o v e r r a t i o r a n k i n g .  This puts the  company on t h e t o p o f t h e l i s t as f a r as t h e r a t e o f r e t u r n on i n v e s t m e n t i s c o n c e r n e d .  N e v e r t h e l e s s , improvements i n  115 "both r a t i o s the  are p o s s i b l e through  company's o p e r a t i o n s  ness,  not  forgetting,  and  a detailed  examination  c o n c e n t r a t i o n on  at the  same time.,  areas  of  o f weak-  to e x p l o i t  fully  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 . 118,  shows a d e t e r i o r a t i o n  Corporation Limited. sales, low  decreased  o f 17.28  dropped from  cent  .80  i n 1956  i n 1956  T a b l e . XV, investigated, i n c o m e , as ranking.' Abitibi  The  to a low  p a g e 12.0,  a per  cent Pulp trend  per  improved'in  cent  turnover  in  per  XIV;  i n 1956  a  last  per  three  companies  i s second  cent, t o 13.46  on  p e r i o d remarkably  the  1956,  per  i n the be  case  taken  1957,  and  and  to  u n c h a n g e d , thus, r e d u c i n g  arrest  The  Limited, to  1957 dropped  i n c r e a s e d to  1958,  o t h e r hand, s t a y e d  of  Limited.  Paper' M i l l s  ratio  investment.  d e c l i n e d f r o m 1956  cent  in its  i n i t s turnover  Paper M i l l s and  ratio  o f 19.32  company's r e t u r n o n  p a g e 119,  to  Therefore,  1958f i n c o m e , as a. p e r c e n t o f s a l e s ,  i n the y e a r s ratio,  of  1958.  Company L i m i t e d , must i n the  Lawrence  a per'cent  in"1958.  indicated  of Anglo-Canadian Pulp  shown i n T a b l e  f r o m 21.20  cent  but  to those  A n g l o - C a n a d i a n . P u l p and  and  .62  shows t h a t o f t h e  of s a l e s ,  Power a n d  the unfavourable  as  of  per  page  company's t u r n o v e r  St Lawrence C o r p o r a t i o n L i m i t e d similar  performance  cent  d e c l i n e d from a high  o f 10.71  Steps,  ;  i n c o m e , as  of. 2.4.15 p e r  i n 1958.  investment t o a. l o w  performance of St  company's  from a high  per  t h e r e t u r n on cent  The  i n the  Table. X I I I ,  16.06  respectively.  d u r i n g the the  The  whole  shock of  wide  fluctuation In  inter-company comparison,  h i g h e s t 'turnover of two on  sales.  ratio  puts  investment  ranking.  previously,  In this  the  the industry  industry  forces  of the three  companies.  o f performance and  i n their rates  an important  conditions  i n question i s  However, t h e f a c t  o f some e x t e r n a l  which exert  are necessary  as i n t h e o i l i n d u s t r y  and t h e companies  s u f f e r e d a. d e c l i n e  existence  i n the r e t u r n  t h e knowledge o f t h e s p e c i a l  on r e m e d i a l s t e p s .  companies  of the  profitability.  n e c c e s s a r y t o make p r o p e r e v a l u a t i o n s advise  The i n t e r a c t i o n  Improvements, i n s a l e s  t h e company's  surrounding  120.)  income a s a p e r c e n t ,  t h e company i n t h e s e c o n d p l a c e  Oonclusions. discussed  t h e company h a s t h e  hut the lowest  ( S e e T a b l e XV, p a g e  forces  to b e t t e r  116  i n income  that  of return  and u n c o n t r o l l a b l e influence  the three indicates  economic  on the performance  117  TABLE X I I RATE OF RETURN ANALYSES A B I T I B I POWER.AND PAPER COMPANY LIMITED  Year  Net sales ($000)  1954 1955 1956 1957 1958  113,998 123,173 132,498 128,199 123,386  Net 'Average income a s s e t s ($000) ($000) 24,446 29,644 32,227 27,204 22,211  155,196 160,087 173,999 188,437 190,237  Income as a p e r cent of sales 21.44 24.06 24.32 21.22 18.00  Turnover  .73 .76 .76 .68 .65  P e r cent r e t u r n on. investment 15.65 18.28 18.48 14.43 11.70  118  TABLE X I I I RATE OF RETURN ANALYSIS ST LAWRENCE CORPORATION - LIMITED  Year  Net. sales ($000)  Net income ($000)  1954 1955 1956 1957 1958  59,358 70,727 78,363 75,696' 68,9'58  12,089 78,434 '15,344 84,756 I8, 929 9 8 , 3 8 8 15/884 114,125 11,920 110,380 :  Average assets ($000)  Income as a per cent of s a l e s 20.36 21.69 24.15 20.98 17.28  Turnover  Per cent r e t u r n on investment  .76 .83 .80 .68 .62  15.47 18.00 19.32  14.27 10.71  119  TABLE X I V RATE OF RETURN ANALYSIS ANGLO-CANADIAN PULP AND PAPER MILLS LIMITED  Year  1954 1955 1956 1957 1958  Net sales ($000) 43,373 46,501 49,337 50,994 55,808  Net " income ($000) 9,763 10,965 10", 462 6\865 8,966  Average assets ($000) 57,447. 63,850 68", 418 72,985 77,585  Income as a per cent of s a l e s 22t5l' 23.58 21.20 13.46 16.06  '  Turnover  .75 .73 .72 .70 .72  Per cent r e t u r n on investment 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. !  Company  Income as a p e r cent of s a l e s  Turnover  Per cent r e t u r n on investment  A b i t i b i Power and; P a p e r Company Ltd,., (Table X I I )  18.00  .,65  11.70  Anglo-Canadian Pulp and P a p e r M i l l s , L t d . , (Table X I V )  16.06  .72  11.56  St Lawrence C o r p o r a t i o n Ltd., (Table X I I I ) 17.28  .62  10.71  

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