Page 84 - DMGT514_MANAGEMENT_CONTROL_SYSTEMS

Unit 4: Responsibility Centers

Working capital in general: There is considerable variation in how working capital items are Notes
treated. At one extreme, companies include all current assets in the investment base, with no
offset for any current liabilities, especially, if the business units have no influence over accounts
payable or other current liabilities. It overstates, the amount of corporate capital required to
finance the business unit. At the other extreme, all current liabilities may be deducted from
Current Assets to calculate the investment base. This provides a good measure of the capital
provided by the corporation on which it expects the business unit to earn a return.
Property Plant and Equipment: In the financial accounting, fixed assets are recorded at acquisition
cost, and the cost is written off over the assets’ useful life by depreciation mechanism. Most
companies use the same asset base in measuring profitability of the business units. The following
points need to be considered:

1. Purchase of new machinery: This can be explained by way of numericals. Suppose the
balance sheet and income statement of a business unit read as follows:
Business Unit Balance Sheet (` 000)

Corporate equity 600 Fixed Assets
Current liabilities- Cost 700
Accounts payable 100 Depreciation 350 350
Other current liabilities 100 200
Current Assets
Cash 60
Receivables 170
Inventory 220 450
800 800

Business Unit Balance Sheet (` 000)
Revenue 1200
Expenses less depreciation 1000
Depreciation (based on straight line method) 50 1050
Income before taxes 150
Capital charge 600  10% (Assumed 10% as normal return) 60
EVA 90

Suppose the business unit has an opportunity to acquire a new machine at a cost of
` 120,000, which is estimated to produce cash savings of ` 33000 a year for
5 years. If the company has a required return of 10%, such an investment is attractive based
on capital budgeting technique as follows:
(` 000)
Investment in machine – life 5 years 120
Cash inflow ` 33,000 per year
Present value of cash inflow 33,000  Cum PV at 10% for 5 years i.e., 33,000  3.791 125
Net present value 5

If the machine is purchased, the reported ROI and EVA of the unit in the 1st year will
decrease, rather than increase. The income statement without the machine and the income
statement if the machine is acquired are shown below:

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