Capital Investment Analysis and Decentralized Performance Measurement
The following exchange occurred just after the finance staff at Diversified Electronics rejected a capital investment proposal.
David Parker (Product Development) : I just don’t understand why you rejected my proposal. We can expect to make $230,000 on it before tax.
Shannon West (Finance) : David, get real. This product proposal does not meet our short term ROI target of 15 percent after tax.
David : I’m not so sure about the ROI target, but it is profitable—$230,000 worth.
Shannon : We believe that a company like Diversified Electronics should have a return on investment of 15 percent after tax. The Professional Services division consistently comes in with a 15 percent or better ROI, while your division, Residential Products, has managed to get only 10 percent. The performance of the Aerospace Products division has been especially dismal, with an ROI of only 6 percent. We expect divisions in the future to carry their share of the load.
Diversified Electronics, a growing company in the electronics industry, had grown to its present size of more than $140 million in sales. (See Exhibits 14.17 and 14.18 for Diversifier’s year 1 and year 2 income statements and balance sheets, respectively.) Diversified Electronics has three divisions, Residential Products, Aerospace Products, and Professional Services, each of which accounts for about one third of Diversified Electronics sales. Residential Products, the oldest division, produces furnace thermostats and similar products. The Aerospace Products division is a large job shop that builds electronic devices to customer specifications. A typical job or batch takes several months to complete. About one half of Aerospace Product’s sales are to the U.S. Defense Department. The newest of the three divisions, Professional Services, provides consulting engineering services. This division has grown tremendously since Diversified Electronics acquired it seven years ago.
Exhibit 14.17 Income Statements— Diversified Electronics
Exhibit 14.18 Balance Sheets— Diversified Electronics
Each division operates independently of the others, and corporate management treats each as a separate entity. Division managers make many of the operating decisions. Corporate management coordinates the activities of the various divisions, including the review of all investment proposals over $400,000.
Diversified Electronics measures return on investment as the division’s net income divided by total assets. Each division’s expenses include the allocated portion of corporate administrative expenses. Since each of Diversified Electronic’s divisions is located in a separate facility, management can easily attribute most assets, including receivables, to specific divisions. Management allocates the corporate office assets, including the centrally controlled cash account, to the divisions on the basis of divisional revenues.
Exhibit 14.19 shows the details of David Parker’s rejected product proposal.
Required
a. Was the decision to reject the new product proposal the right one? If top management used the discounted cash flow (DCF) method instead, what would the results be? The company uses a 15 percent after tax cost of capital (i.e., discount rate) in evaluating projects such as these.
b. Evaluate the manner in which Diversified Electronics has implemented the investment center concept. What pitfalls did it apparently not anticipate? What, if anything, should be done with regard to the investment center approach and the use of ROI as a measure of performance?
c. What conflicting incentives for managers can occur when yearly ROI is used as a performance measure and DCF is used for capital budgeting?
Exhibit 14.19 Data—New Product Proposal
a Annual capacity of 120,000 units.
b Includes straight line depreciation on new plant and equipment, depreciated for eight years with no net salvage value at the end of eight years.