Reports on the economic performance of business units are quite different. Management reports are prepared monthly or quarterly, whereas economic performance reports are prepared at irregular intervals usually once every several years. For reasons stated earlier, management reports tend to use historical information actual costs incurred, whereas economic reports use quite different information. In this section we discuss the purpose and nature of the economic information.
Economic reports are a diagnostic instrument. They indicate whether the current strategies of the business unit are satisfactory and, if not, whether a decision should be made to do something about the business unit- expand it, shrink it, change its direction, or sell it. The economic analysis of an individual business unit may reveal that current plans for new products, new plant and equipment, or other new strategies, when considered as a whole, will not produce a satisfactory future profit, even though, separately each decision seemed sound when it was made.
Economic reports are also made as a basis for arriving at the value of the company as a whole. Such a value is called the breakup value-that is, the estimated amount that shareholders would receive if individual business units were old separately. The breakup value is useful to an outside organization that is considering making a takeover bid for the company, and, of course, it is equally useful to company management in appraising the attractiveness of such a bid. The report indicates the relative attractiveness of the business units and may suggest that senior management is mis-allocating its scarce time-that is, spending an large amount of time on business units that are unlikely to contribute much to the company’s total profitability. A gap between current profitability and breakup value indicates changes may need to be made. (Alternatively, current profitability may be depressed by costs that will enhance future profitability, such as new product development and advertising.)
The most important difference between the two types of reports is that economic reports focus on future profitability rather than current or past profitability. The book value of assets and depreciation based on the historical cost of these assets is used in the performance reports of managers, despite their known limitations. This information is irrelevant in reports that estimate the future; in these reports, the emphasis is on replacement costs.
Conceptually, the value of a business unit is the present value of its future earnings stream. Estimating cash flows for each future year and discounting each of these annual flows at a required earnings rate calculate this. The analysis rovers five, or perhaps ten, future years. Assets on hand at the end of the period covered are assumed to have a certain value-the terminal value, which is discounted and added to the value of the annual cash flows. Although these estimates are necessarily rough, they provide a quite different way of looking at the business units from that conveyed in performance reports.