 Hello, and welcome to the session in which we would look at performance measurement. Performance measurement is used for the internal assessment of various divisions at the company to reward people like managers. And from a company's perspective, they break down their responsibility accounting into four different centers, revenue centers, cost centers, profit centers and investment centers. If your center is a revenue center, it means your division or your center only generates revenues, we're going to evaluate your performance based on variances, whether you meet or exceed your revenue, cost centers the same way. If you let's assume you are a customer service department or an IT department, you don't generate any revenues, you only incur cost. Well, we're going to be looking at variances. If your division can have control over revenues and expenses, then you are considered the profit centers and we are going to judge you based on the profit. Investment centers, what's going to happen is, in addition to the profit, so you're going to have revenues and expenses, we're going to be adding assets to the equation. Assets in the sense that we want to value or evaluate your performance based on your usage of the asset, how well or not well you are using those assets to generate profit. So this is what we're going to be talking about in the session, investment centers. Before we start, I would like to remind you if you are an accounting students or especially if you're a CPA candidate, this topic is covered on the CPA exam. I don't replace your CPA review course. I don't replace your Becker, Roger, Gleam or Wiley. I can't. What I can be, I can be a useful addition to your CPA course. I explain the material a little bit more in depth and details than the other courses. I can add 10 to 15 points to your CPA exam by helping you understand the material. Are you willing to make that trade? Are you willing to risk $29, $30 to try out whether I can really improve your performance? If you're willing to do so, here's your risk, $30. You're upside, passing the CPA exam. Are you willing to take that risk? Okay. And if not for anything, check out my website so you will find out how well is your university on average doing on the CPA exam. This should give you an idea how rigor is your accounting program. Also, I do have other accounting courses that I cover, but what I suggest you do is connect with me on LinkedIn and check out my LinkedIn recommendations. This is where students use my material for the CPA exam and see how well it worked for them. Please like this recording, share it on YouTube. If it helps you, it might help others connect with me on Facebook and Instagram. So let's go back to investment centers. What is investment centers? Investment centers, I'm going to look at your performance from a revenue expense perspective, which is profit. Also, I'm going to look and see how well you are utilizing your assets, basically, and it's an efficiency ratios, asset utilization. So not only you are responsible for profit now, but I want to see how well you are using your assets. And this should make, this should make sense. Because if you have more assets under your control, assets are resources. Well, if you have resources, how well you are utilizing those resources? If I'm looking at two different divisions, if one division has more assets than the other, then you would expect that division to generate more in revenues because they have more resources under their control. So basically, in an investment center, we are marrying the profit with the assets. We're looking at the profit, but we want to see how well you are doing in relationship to the invested asset. And to measure this, we look at something called return on investment. The simplest explanation of return on investment is some sort of an income, net operating income, income after taxes, divided by some measure of assets. This is how we come up with ROI. Now, again, income could be considered operating income or not, or after tax income. After tax income usually is simply net income. So different tax book use compute that numerator differently, whether they use operating income or after tax income. It doesn't matter. But the idea is some sort of income. Assets also, you could use more than one type of assets. They can look at your beginning assets that's in your denominator. They could look at your average assets or they can only look at your ending assets. It has to be consistent from year to year for this to make sense. Most companies would use average assets and it makes sense to use average assets because what you can do at the end of the year, you can get rid of some of your assets and your assets are lower. If your assets are lower, your ROI is higher. Therefore, using average asset is the best. But the way we compute, the way we use assets in the denominator is really up to the company. As long as they're consistent, it doesn't really matter. Also how we value asset. Some companies value asset at acquisition cost. So that number in the denominator is based on the purchase, historical purchase cost of the asset. Some companies use the depreciated cost, which is the book value, which is the asset minus its accumulated depreciation. And simply put, if you have old assets with the book value as low, your ROI simply went up. Not because you are doing a better job, just because your assets are already depreciated. But it's good that you are utilizing those assets to generate income. Or some companies would use the replacement cost of your assets. Again, it doesn't matter which method you use, as long as it's consistent across the board, across all divisions from year to year, that's fine. Now, the best way to illustrate this is to actually work an example to see how we compute return on investment. Let's assume we have two divisions. One is the North Division and the other one is the South Division. We have sales for the North Division 100,000, South Division 280, net operating income 10,000. So I'm going to be using NOI, net operating income, 10,000 for the North Division, 40,000 for the South Division. Average assets, I'm going to be using average assets, 50,000 for the North Division, 300,000 for the South Division. I'm going to first compute return on investment, which is basically taking net income divided by average assets gives us 20%. So 20% for the North Division, for the South Division, 40,000 divided by 300,000, 13.33. Now, obviously, right from the get go, we can see that the North Division is utilizing their assets better than the South Division, just from a return on investment perspective. Well, but that doesn't tell us much. We want to know a little bit more about those divisions. We want to know how well they are generating profit or how well they are using their assets. Here's what's going to happen. The formula for return on investments is NOI, net operating income divided by the assets or average assets, okay? And this is what's given us this 20%, 10,000 divided by 50. Here's what I'm going to do. I'm going to be using what's called the Dupont analysis, and I'm going to expend this formula, break it down into several component. Well, we're not going to break it down into the five Dupont analysis component. If you want to go to my website, I do have that lecture, but we don't cover this in here. So I'm going to multiply this by, guess what, I'm going to multiply this by one. And one, I'm going to multiply this by sales divided by sales, which is sales divided by sales equal to one. So if I multiply something by one, it should give me the same figure. Then I'm going to manipulate this formula a little bit. I'm going to rearrange the denominator. I'm going to take assets, put it in assets at the other side and move sales to this end, which it's going to give me the same thing and just manipulating the formula. What I have now is NOI divided by sales times sales divided by assets. And that's the same thing. What did I do? Well, guess what? I took this formula and I broke it down into two component. This is called the profit margin. And hopefully you know what the profit margin is. And this is called the turnover or asset turnover. Now, it's not going to change my total. My total, it's going to be 20% for the North Division, 13.33 for the South Division. The only thing I'm going to find out now is how well the North Division is generating profit margin, how well the South Division is generating profit margin and asset turnover. Therefore, I'm going to go ahead and compute this. For the profit margin, the North Division, we can see that they are keeping 10% for every dollar in sales. How do I compute this? Well, again, NOI, which is $10,000 divided by sales of 100,000, okay? So the North Division is 10%. For the South Division, sales is, I'm sorry, net operating income is 40. Let's do, this is for the North Division. For the South Division, it's going to be 40,000 divided by 280,000 and that's equal to 13.33. What can we say now? We can say that from a profit perspective, the South Division is making, keeping more profit per dollar amount. In other words, they are controlling their expenses better than the North Division because they're keeping 14, not 13, sorry, 14.29, 14.29 of every dollar in sales. So for every $100, they're keeping $14.29 in profit. The North Division is only keeping $10. Now, we have now to compute the asset turnover. When we compute the asset turnover, which is sales divided by assets, which is sales divided by asset, we see that the turnover for the North Division is 200 or two, okay? What does that mean? For the North Division, for every dollar in asset, because they have 50,000, they're generating $2 in sales. However, when it comes to the South Division, for every dollar in assets, if we take sales divided by average asset, they're only generating 93 pennies. For every dollar, they're generating 93 pennies, okay? So notice from a turnover perspective, from a turnover perspective, the North Division is utilizing their assets better to generate sales. Why? Because the asset turnover is two or 200 and the South Division 0.93 or 93.33. So now we can see that those divisions, they can learn from each other. So the South Division should learn how to use their assets better to generate more sales and the North Division would learn from the South Division how to control costs to increase their profit margin. That will be great. But what we did now is we kind of break it down to find out a little bit more about the company. And notice if we take, if we multiply 10% by 200%, we'll give us 20%. If we multiply 14.29 times 0.993, we'll give us 13.33, which is what we computed earlier. All what we did is we learned a little bit more about how well the company is using their assets, how well they are keeping profit from every dollar in sales. Now let's take a look at advantages and disadvantages of ROI. What are the advantages of ROI? Pretty simple, the data is available, we have return, we have net income, it's an accounting figure, we have assets, simple and straightforward to compute. So that's the advantage. The disadvantages is the ROI will give the manager a short-term orientation vision. What does that mean? It means managers are not interested in investing in new asset, why? Because this is your ROI. When you increase the numerator, the denominator, when you increase your assets, you're gonna reduce your ROI. So that's why they're not interested. And remember, net operating income is profit. So if you want to increase your ROI, you want to increase your profit. So what you do to increase your profit, you cut on research and development, you cut on maintenance expenditure, yes, you can increase your ROI. But what's gonna happen is those two aspects, investing in assets and investing in R&D, what they do is they benefit you on the long term. ROI is telling the managers, well, if we're evaluating you based on ROI, we're not giving you any incentive to invest. Also ROI, look at historical data, which is it's a lagging indicator, accounting figures are old figures. And there's some sort of sub optimization, which is related to this one here, is managers make decision to benefit themselves, to benefit their division, not company overall. So let's illustrate this concept here, the problem with really with ROI. Well, let's assume the North Division, they have an opportunity to invest an additional 200,000. And as a result, their operating income will increase by 30,000. Let's see what would happen if that occur. Well, if that occur, the manager of the North Division, now what's gonna happen to their ROI, it becomes 16%. Why? The old operating income was 10,000, the old average assets was 50. If we add the 30,000 and the 200,000, if we add them, now their return on investment equal to 16%. Remember, the return on investment was 20% for the manager of the North Division. So the manager of the North Division will say, look, my ROI is 20%. If I undertake this project and I expand, my ROI would be lower. Okay, now, is this good or bad for the company? Well, let's take a look at the company overall without the expansion. If we look at the numbers, if we add everything up without the expansion, we find out that the company's ROI 14.29. So notice the manager, it's still doing more than the overall company's ROI, okay? 16%, still more 14.29, but the manager doesn't want to look bad, okay? And let's look at ROI with the expansion. So if we did undertake the expansion, ROI for the company, all what I'm doing is here, is adding the 30,000 to the 2000 and adding the 200,000 to the 50,000 and adding everything up and performing the computation again. Notice with the expansion, ROI for the company will be 14.55, which will improve. So the company overall will improve. However, the manager themselves, they would not look good. Why? Because the ROI went down. And this is what, this is what I said. There is a sub-optimizing decisions because the managers are looking after their own interests. Now what's gonna happen in the next session, we're gonna be looking at another form of performance that's gonna alleviate this problem. And we'll talk about this in the next session. Again, at the end of this recording, I'm gonna invite you to like this recording, visit my website, forhatlectures.com. And remember, if you're studying for your CPA exam, don't shortchange yourself. I don't replace your CPA prep course. I can be a useful addition. Don't shortchange yourself. Investing in your CPA is a long time, is a long-term career investment. It's gonna be 30 to 40 years. It's gonna pay dividend for you. Good luck, study hard, and most importantly, stay safe.