Page 85 - DMGT514_MANAGEMENT_CONTROL_SYSTEMS

Management Control Systems

Notes Without First year
the with
machine machine
Revenue 1200 1200
Expenses less 1000 1000 – 33 = 967
depreciation
Depreciation 50 1050 50 + 24 = 74 1041
Income before taxes
Capital charge 150 159
10% on 600 60 10% on 600 + 120 72
EVA 90 87
ROI 150 25% 159 22.1%
600 720

Under these circumstances, the business unit manager may be reluctant to purchase this
machine. Even in later years, the amount of residual income will increase, as the book
value of the machine declines, though in reality there is no real change in profitability in
subsequent years after the machine was acquired. If profitability is measured by return on
investment, as the year progresses, ROI increases from 1st year of 7.5% to 37.5% in the fifth
year, although we know from the present value calculation, the true return is about 11%.
The calculations are shown below:

Year Book value at Income Capital charge EVA ROI
beginning of year (2) (3) (2) – (3) 2 – 1
(1) [33-24 = 10% on (1)
Saving Depr.]
1 120 9 12 -3 7.5%
2 96 9 9.6 -0.6 9.5
3 72 9 7.2 1.8 12.5
4 48 9 4.8 4.2 18.75
5 24 9 2.4 6.6 37.50
It is evident that, if depreciable assets are included in the investment base at net book
value, business unit profitability is misstated, with the result, business unit manager may
not be motivated to make correct purchase decisions.
The fluctuation in EVA and return on investment from year to year as shown above can be
avoided by including depreciable assets in the investment base at gross book value, rather
than net book value. In such a case, the investment each year would be shown at the
original cost of ` 120,000, additional income will be ` 9000 (cash saving 33,000 minus
depreciation of ` 24000). EVA each year will be negative ` 3000 (` 9000 minus capital
charge ` 12000) and the ROI would be 7.5% (9000, 120,000). Both these numbers indicate
that business units profitability has decreased which, in fact, is not the case.

2. Replacement of machinery: If a new machine is being considered as a replacement of
existing machinery that has some undepreciated book value, the undepreciated book
value is irrelevant in the economic analysis of the proposed purchase (except indirectly as
it may affect income taxes). Whereas, for calculation of asset base (for the profitability
calculation of business unit), net book value will only increase by the difference between
the net book value after year I of the new machine and the net book value of the old
machine. The result is, the relevant amount of additional investment is understated and
residual income is correspondingly overstated. Managers will, therefore, be motivated to
replace old equipment with new machinery even in situation when such replacement is
economically not viable.

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