Divisional Performance Measurement

1 Introduction

In this chapter we will consider the situation where an organisation is divisonalised (or decentralised) and the importance of proper performance measurement in this situation.

We will also consider the possible problems that can result from the use of certain standard performance measures.

2 The meaning of divisionalisation

As mentioned earlier, divisionalisation is the situation where managers of business areas are given a degree of autonomy over decision making i.e. they are given the authority to make decision without reference to senior management. In effect they are allowed to run their part of the business almost as though it were their own company.

2.1 Advantages of divisionalisation:

• Specialism in product/country/customer
  

• Greater motivation for managers
  

• Allows divisions to be profit centres (motivating and promotes efficiency)
  

• Allows performances between divisions to be compared
  

• Clearer objectives for managers (concentrate on one area of the business only)
  

• Usually accompanied by decentralization, so potentially better decisions.
  

2.2 Problems with divisionalisation:

• Coordination difficulties
  

• Requires transfer prices to be established
  

• Lack of goal congruence/dysfunctional decision-making
  

• Difficulties in ‘fair’ comparison of divisions.
  

• Potential duplication of some services
  

3 The use of performance measures to control divisional managers

If managers are to be given autonomy in their decision making, it becomes impossible for senior management to ‘watch over’ them on a day-to-day basis – this would remove the whole benefit of having divisionalised!

The way to control their performance is to establish in advance a set of measures that will be used to evaluate their performance at (normally) the end of each year. These measures provide a way of determining whether or not they are managing their division well, and also communicate to the managers how they are expected to perform.

It is of critical importance that the performance measures are designed well.

For example, suppose a manager was simply given one performance measure – to increase profits. This may seem sensible, in that in any normal situation the company will want the division to become more profitable. However, if the manager expects to be rewarded on the basis of how well he achieves the measure, all his actions will be focussed on increasing profit to the exclusion of everything else. This would not however be beneficial to the company if the manager were to achieve it by taking actions that reduced the quality of the output from the division. (In the long- term it may not be beneficial for the manager either, but managers tend to focus more on the short-term achievement of their performance measures.)

It is therefore necessary to have a series of performance measures for each division manager.

Maybe one measure will relate to profitability, but at the same time have another measure relating to quality. The manager will be assessed on the basis of how well he has achieved all of his measures.

We wish the performance measures to be goal congruent, that is to encourage the manager to make decisions that are not only good for him but end up being good for the company as a whole also.

In this chapter we will consider only financial performance. However, non-financial performance is just as important and we will consider that in the next chapter.

4 Controllable profits

The most important financial performance measure is profitability.

However, if the measure is to be used to assess the performance of the divisional manager it is important that any costs outside his control should be excluded.

For example, it might be decided that pay increases in all division should be fixed centrally by human resources staff at Head Office. In this case it would be unfair to penalise (or reward) the manager for any effect on the division’s profits in respect of this cost. For these purposes therefore a profit and loss account would be prepared ignoring wages and it would be on the resulting controllable profit that the manager would be assessed.

5 Investment centres and the problem with measuring profitability.

As stated earlier, divisionalisation implies that the divisional manager has some degree of autonomy.

In the case of an investment centre, the manager is given decision-making authority not only over costs and revenues, but additionally over capital investment decision.

In this situation it is important that any measure of profitability is related to the level of capital expenditure. Simply to assess on the absolute level of profits would be dangerous – the manager might increase profits by $10,000 and be rewarded for it, but this would hardly be beneficial to the company if it had required capital investment of $1,000,000 to achieve!!

The most common way of relating profitability to capital investment is to use Return on Investment as a measure. However, as we will see, this can lead to a loss of goal congruence and a measure known as Residual Income is theoretically better.

6 Return on Investment (ROI)

ROI is defined as:   Controllable division profit as a percentage of divisional investment

It is equivalent to Return on Capital Employed and this is one of the reasons that it is very popular in practice as a divisional performance measure.

In the above example, the manager is motivated to accept an investment that is attractive to the company as a whole. He has been motivated to make a goal congruent decision.

Note that in this illustration we have used the opening book value for capital invested. In practice it may be more likely that we would use closing book value (which would be lower because of depreciation). There is no rule about this – in practice we could do whichever we thought more suitable. However, in examinations always use opening book value unless, of course, you are told to do differently.

However, there can be problems with a ROI approach as is illustrated by the following example:

In this example the manager is not motivated to make a goal congruent decision. For this reason, a better approach is to assess the manager’s performance on Residual Income.

7 Residual Income (RI)

Instead of using a percentage measure, as with ROI, the Residual Income approach assesses the manager on absolute profit. However, in order to take account of the capital investment, notional (or imputed, or ‘pretend’) interest is deducted from the Income Statement profit figure. The balance remaining is known as the Residual Income.

(Note that the interest charge is only notional, and is only made for performance measurement purposed).

Note that in both cases the manager is motivated to make goal congruent decisions.

8 ROI vs RI

Note that both RI and ROI will favour divisions with older assets because those divisions will:

1. Probably have bought the assets more cheaply than new divisions which buy at inflated prices.
   

2. The assets are more heavily depreciated so that the capital employed figures is less in the division with older assets – and this affects both the denominator in ROI and the notional interest charge in RI
   

3. Both methods can also suffer distortions because of assets leased on operating leases and also if head office accounts for some ‘divisional’ assets (for example HO holding all receivables).
   

In practice, ROI is more popular than RI, despite the fact that RI is technically superior in terms of encouraging managers to make the correct investment decisions.

Pros and cons of ROI:

It seems familiar – most managers will know about return on capital calculations.

• Easy: compare ROI with a company target.
  

• Encourages maximization of ROI which might be how congruent with shareholders judge the company.
  

• Good for comparing divisions of different sizes
  

BUT

• Decisions will not necessarily maximize shareholder wealth.
  

Pros and cons of RI:

• RI maximization tends to be congruent with decisions that maximise shareholder wealth
  

• Different notional interest rates can be set for investment of different risk.
  

BUT

• A less familiar calculation and concept
  

• Not good at comparing divisions of different sizes. (Larger RIs might simply be a function of bigger divisions).

9 Annuity Depreciation

Despite the points made above, even if we use a Residual Income approach there is a danger of non-goal congruent decisions being made because divisional managers tend to think short-term. (The same problem applies to ROI approaches also). This is because in early years the book value of any new investment is high and this depresses both the ROI and RI.

A solution to this problem is to use annuity depreciation.

We will illustrate the nature of the problem, and the solution of annuity depreciation by means of an example.

10 Economic Value Added

Economic value added (EVA) is a performance metric that is very similar in approach to Residual Income, and is defined as being:

EVA = Net operating profit after tax – WACC x book value of capital employed

EVA is a trade-marked technique, developed by consultants called Stern Stewart and Co.

The principle behind it is that a business is only really creating value if its profit is in excess of the required minimum rate of return that shareholders and debt holders could get by investing in other securities of comparable risk.

The capital employed is the opening capital employed, adjusted fro the items set out below.

EVA allows all management decisions to be modelled, monitored, communicated, and compensated in a single and consistent way – always in terms of the value added to shareholder investment.

However, EVA makes certain adjustments because certain types of expenditure which appear in the statements of profit and loss under ISAs and IFRSs are NOT regarded as expenses when using EVA and cash accounting is regarded as more reliable than accruals accounting).

The major adjustments are:

Add back to profits:

• Expenditure on building for the future (e.g. research expenditure, marketing expenditure and staff training):
  

• Non-cash expenses
  

• Provisions
  

• Goodwill written off
  

• Depreciation: add back book depreciation and deduct economic depreciation. If economic depreciation is not given, assume it is the same as book depreciation and that there is no net adjustment.
  

• Interest on debt capital
  

Add back to net profit after adjusting for any tax relief.

Treat the debt as part of capital employed

Adjustment to statement of financial position

• Non capitalized leases
  

• Research etc now capitalised
  

• Goodwill written off
  

• Provisions

11 Potential problems of EVA

• It is difficult to use EVA to compare firms or divisions because it is an absolute measure and takes no account of the relative size of the business.
  

• Because EVA is a year-to-year measure, it could be improved in the short term but to the detriment of the business in the long term.
  

• Economic depreciation is difficult to calculate and conflicts with generally accepted accounting principles.
  

• Other factors that could be important but are not included in the accounts are ignored.
  

• EVA is a short-term measure whereas performance measures should focus on the longer- term forecasts. Ideally economic income would be used (by discounting estimated future cash flows) but even ignoring the complexity of this, the person responsible for estimating it would very often be the person being measured, which could lead to bias.