Full List of Management Accounting for Decision Makers_13 doc

Household Appliances Divisional Income Statement for last yearDivisional profit before common expenses 210 Divisional profit loss for the period 130 Before looking at the various measure

We can see that divisionalisation poses a major challenge for top management.Somehow, it must encourage management discretion at the divisional level whilst try-ing to ensure that the divisional objectives are consistent with the overall strategicobjectives of the business as a whole This requires sound judgement, as there are really

no techniques or models that can be applied to solve this problem

A further challenge for top management is to identify valid and reliable performancemeasures that can help assess both the division and its divisional managers It is to thischallenge that we now turn

Businesses operate with the financial objective of increasing shareholders’ wealth,which on a short-term basis translates into making a profit It is not surprising, there-fore, that profits and profitability are of central importance in measuring the per-formance of both the operating divisions and their divisional managers There are,however, various measures of profit that we can use for these purposes When decid-ing on the appropriate measure, it is important to be clear about the purpose for which

it is to be used

To help understand the issues involved, let us take a look at the following divisionalincome statement We can see that it incorporates various measures of profit that can

be used to assess performance and we shall consider each of these in turn

Measuring divisional profit

the business as a whole Though such a policy would cut across the autonomy of divisionalmanagers, it is important for them to appreciate that they are not operating completelyindependent units and that divisional managers also have responsibilities towards thebusiness as a whole

The problem of risk avoidance by management is a complex one that may be difficult

to deal with in practice It might be possible, however, to encourage divisional managers

to take on more risk if the rewards offered reflect the higher levels of risk involved.Observation of real life tells us that individuals will often be prepared to take on greater riskprovided that they receive compensation in the form of higher rewards

If things start to go wrong, it may also be possible for the business, through the use ofbudget variance reports, to distinguish between those variances that are outside the con-trol of the divisional manager and those that are within the manager’s control Divisionalmanagers would then be accountable only for the variances within their control It is notalways easy, however, to obtain unbiased information for preparing budgets from divisionalmanagers when they know that such information will be used to evaluate their performance.Management perks may be controlled by central management by setting out clear rules as to what is acceptable To some extent, observing the behaviour and actions ofdivisional managers can reveal departures from the rules Many perks, such as luxury cars,chauffeurs and large offices, are highly visible Central management should be alert to anysigns that divisional managers are rewarding themselves in this way

Duplication of effort in certain areas can be extremely costly For this reason, somebusinesses prefer particular functions, such as administration, accounting, research anddevelopment and marketing, to be undertaken by central staff rather than at the divisionallevel Again, this means that divisional managers will have to sacrifice some autonomy forthe sake of the performance of the business overall

Activity 10.2 continued

Household Appliances Divisional Income Statement for last year

Divisional profit before common expenses 210

Divisional profit (loss) for the period 130

Before looking at the various measures of profit, we should be clear that the words

‘controllable’ and ‘non-controllable’ in this income statement refer to the ability of thedivisional manager to exert an influence over particular expenses Thus, an expensethat is authorised by a senior manager at head office will not be under the control ofthe divisional manager, despite the fact that the expense may relate to the division Anexpense that arises directly from a decision taken by the divisional manager, on theother hand, is controllable at divisional level

As is implied by this income statement for the division, there are four measures ofprofit that could be used to assess performance These are: contribution; controllableprofit; divisional profit before common expenses; and divisional profit for the period

Contribution

The first measure of profit is the contribution, which represents the difference between

the total sales revenue of the division and the variable expenses incurred We consideredthis measure at length in Chapter 3 There we saw that it can be a useful measure forgaining an insight into the relationship between costs, output levels and profit

Assume that you are the chief executive of a divisionalised business Would you use contribution as a primary measure of divisional performance?

This measure has its drawbacks for this purpose The most important drawback is that

it only takes account of variable expenses and ignores any fixed expenses incurred Thismeans that not all aspects of operating performance are considered

Activity 10.3

Assume now that you are a divisional manager What might you be encouraged to do

if the contribution were used to assess your performance?

As variable expenses are taken into account in this measure and fixed expenses areignored, it would be tempting to arrange things so that fixed expenses rather than variableexpenses are incurred wherever possible In this way, the contribution will be maximised

For example, you may decide, as divisional manager, to employ less casual labour and touse machines to do the work instead (even though this may be a more expensive option)

Activity 10.4

MEASURING DIVISIONAL PROFIT 373

Controllable profit

The second measure of profit is the controllable profit, which takes account of all

expenses that are within the control of divisional managers in arriving at a measure

of performance Many view this as the best measure of performance for divisional managers, as they will be in a position to determine the level of expenses incurred.However, in practice, it may be difficult to categorise costs as being either controllable costsor non-controllable costs Some expenses may be capable of being influenced bydivisional managers, yet not be entirely under their control

Depreciation can be one example of such an expense The divisional manager may

be required to purchase a particular type of computer hardware so that the tion systems of the division are compatible with the systems used throughout the busi-ness The manager may, however, have some discretion over how often the hardware

informa-is replaced, as well as over the purchase of particular hardware models that performbeyond the requirement standards needed for the business By exercising this discretion,the depreciation charge for the year will be different from the one that would arise ifthe manager stuck to the minimum standards laid down by central management

Divisional profit before common expenses

The third measure of profit is divisional profit before common expenses, which takes

account of all divisional expenses (controllable and non-controllable) that are incurred

by the division This provides us with a measure of how the division contributes to theoverall profits of the business

Which one of the three measures that we have discussed so far is most useful for evaluating the performance of divisional managers, and which for evaluating the per- formance of divisions?

It can be argued that the performance of divisional managers should be judged on thebasis of those things that are within their control Hence, the controllable profit would bethe most appropriate measure to use The contribution measure does not take account ofall the expenses that are controllable by divisional managers, whilst the divisional profitbefore common expenses takes account of some expenses that are not under the control

of divisional managers The latter measure, however, may be appropriate for evaluatingthe performance of the division, as it deducts all divisional expenses from the divisionalrevenues earned It is a fairly comprehensive measure of divisional achievement

Activity 10.5

Divisional profit for the period

The final measure of profit is divisional profit for the period, which is derived after

deducting a proportion of the common expenses incurred for the period The expensesapportioned to each division will presumably represent what central managementbelieves to be a fair share of the total common expenses incurred These expenses will typically include such things as marketing, personnel, accounting, planning, information technology and research and development expenses In practice, the

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way that these apportionments are made between divisions can be extremely tious Some divisional managers may be convinced that they have been apportioned

conten-an unfair share of the common expenses They may also believe that the divisions arebeing loaded with expenses over which they have little control and that the divisionalprofit figure derived will not truly represent the achievements of the division These are often compelling arguments for not apportioning common expenses to the variousdivisions

Can you think of any arguments for apportioning common expenses to divisions?

The business as a whole will only make a profit after all common expenses have been ered Apportioning these expenses to the divisions should help make divisional managersmore aware of this fact In addition, top management may wish to compare the results ofthe division with the results of similar businesses in the same industry that are operating

cov-as independent entities By apportioning common expenses to the divisions, a more validbasis for comparison is provided Independent businesses will have to bear these kinds of

expenses before arriving at their profit for the period The effect of apportioning common

expenses may also help to impose an element of control over these expenses Divisionalmanagers may put pressure on top managers to keep common expenses low so as tominimise the adverse effect on divisional profits

We can see that the costs of using common resources tend to be fairly low The sons for this are not entirely clear One possible explanation is that highly decentralisedbusinesses tend to have divisions that are self-reliant Hence, the level of dependence oncommon resources will be low Another possible explanation is that businesses with alarge number of divisions have a greater opportunity to spread the costs of commonresources among the various divisions The study found, however, little or no evidence tosupport these explanations

rea-MEASURING DIVISIONAL PROFIT 375

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Divisional profit, by itself, is an inadequate measure of divisional performance Someaccount must be taken of the investment in assets required to generate that profit Twowell-established measures of divisional performance that do this are

We shall deal with both of these measures in turn

Return on investment (ROI)

Return on investment (ROI)is a well-known method of assessing the profitability ofdivisions The ratio is calculated in the following way:

When defining divisional profit for this ratio, the purpose for which the ratio is to

be used must be considered For evaluating the performance of a divisional manager,the controllable profit is likely to be the most appropriate, whereas for evaluating the performance of a division, the divisional profit for the period is likely to be more appropriate Various definitions can be used for divisional investment The total

Divisional profit Divisional investment (assets employed)

Divisional performance measures

‘

Real World 10.3 continued

Common costs as a percentage of divisional annual sales revenue

Figure 10.3

Common costs represent 10 per cent or less of the annual sales revenue of a division for nearly three-quarters of respondents.

Source: Drury, C and El-Shishini, E., ‘Divisional performance measurement: an examination of potential explanatory factors’,

CIMA Research Report, August 2005, p 32.

assets (non-current assets plus current assets) or the net assets (non-current assets plus current assets less current liabilities) figure may be used In addition, non-currentassets may be shown at their historic cost, or their historic cost less accumulated depre-ciation, or on some other basis, such as current market value.

It is important that, whichever definitions of divisional profit and investment areused, there is absolute consistency It could be very misleading to try to compare theROIs of two different divisions using one set of definitions for one division and anotherset for the other division

The ROI ratio can be broken down into two main elements These are:

This separation into the two main elements is useful, because it shows that ROI

is determined by both the profit margin on each £ of sales revenue and the ability togenerate a high level of sales revenue in relation to the investment base

Sales revenueDivisional investment

Divisional profitSales revenue

The following data relate to the performance and position of two operating divisions that sell similar products:

Kuala Lumpur Singapore Division Division

What observations can you make about the performance of each division?

First, the ROIs for both divisions are identical at 5 per cent a year (that is, 30/600 and25/500) The information shows, however, that the divisions appear to be pursuing differ-ent strategies The profit margins for the Kuala Lumpur and Singapore Divisions are 10 percent (that is, 30/300) and 3.3 per cent (that is, 25/750) respectively The sales revenue todivisional investment ratios for the Kuala Lumpur and Singapore Divisions are 50 per cent(that is, 300/600) and 150 per cent (that is, 750/500) respectively Thus, we can see thatthe Kuala Lumpur Division prefers to sell goods at a higher profit margin than theSingapore Division, resulting in lower sales revenue to assets employed

Activity 10.7

ROI is a measure of profitability, as it relates profits to the size of the investment made

in the division This relative measure allows comparisons between divisions of ent sizes However, ROI has its drawbacks Where it is used as the primary measure ofperformance for divisional managers, there is a danger that it will lead to behaviourthat is not really consistent with the interests of the business overall

differ-DIVISIONAL PERFORMANCE MEASURES 377

Russell Francis plc has two divisions, both selling similar products but operating in ferent geographical areas The Wessex Division reported a £200,000 controllable profit from a divisional investment of £1m and the Sussex Division a £150,000 controllable profit from a divisional investment of £500,000.

dif-Activity 10.8

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A further disincentive to invest can result where the divisional investment in assets

is measured in terms of the original cost less any accumulated depreciation to date(that is, written-down value or net book value) Where depreciation is being chargedeach year, the written-down value of the divisional investment will be reduced.Provided that profit stays at the same level, this means that ROI will climb during thelifetime of the depreciating assets

To illustrate this point consider Example 10.1

The following are the profits and investment for a division over a four-yearperiod:

Year Divisional Divisional ROI at net

profit investment book value

Which operating division has been the more successful? How might each divisional manager react to the new opportunity?

Although the Wessex Division has achieved a higher profit in absolute terms, it has a lower ROI than the Sussex Division The ROI for Wessex is 20 per cent a year (that is,

£200,000/£1,000,000) compared with 30 per cent (that is, £150,000/£500,000) for theSussex Division Using ROI as the measure of performance, the Sussex Division is there-fore the better-performing division

The ROI from the new investment is 25 per cent a year (that is, £50,000/£200,000).Thus, by taking on this investment, the divisional manager of Wessex will increase the ROI of the division, which currently stands at 20 per cent a year However, the divisionalmanager of Sussex will reduce the ROI of the division by taking this opportunity as its ROI

is below the overall ROI of 30 per cent a year for the division

If ROI is used as the primary measure of divisional performance, the divisional manager

of Sussex may decline the opportunity for fear that a reduction in divisional ROI will reflectpoorly on performance However, the return from the opportunity is 25 per cent a year,which comfortably exceeds the minimum ROI of 16 per cent a year So failure to exploitthe opportunity will mean the profit potential of the division is not fully realised

This activity illustrates the problems that can arise when using comparative measures,such as percentages

Activity 10.8 continued

Residual income (RI)

The weaknesses of the ROI method, particularly the fact that it ignores the cost offinancing a division, has led some businesses to search for a more appropriate measure

the amount of income, or profit, generated by a division, which is in excess of the imum acceptable level of income If we assume that the objective of the business is toincrease owners’ (shareholders’) wealth, the minimum acceptable level of income to begenerated is the amount necessary to cover the cost of capital

min-Taking the divisional profit figure and then deducting an imputed charge for thecapital invested gives the RI Example 10.2 should make the process clear

We can see that the ROI increases over time simply because the investment base

is shrinking This is despite the fact that it is the same equipment, generating asmuch profit We saw above that divisional managers may be discouraged frominvesting in further assets where the ROI is below the existing ROI for the divi-sion In this example, the divisional manager would probably be reluctant toreplace the equipment and expose the division to a 15 per cent ROI This would

be the case even though the need for new investment is likely to increase as theexisting equipment becomes fully depreciated

How might the problem caused by ROI being boosted simply through a reduction in the investment base, as in Example 10.1, be dealt with?

One way around the problem would be to keep the investment in assets at original costand not to deduct depreciation for purposes of calculating ROI However, non-currentassets normally lose their productive capacity over time, and this fact should really berecognised Another way around the problem is to use some measure of current marketvalue, such as replacement cost, for the investment in assets However, there may beproblems in establishing current values for some assets

Activity 10.9

A division produced a profit of £100,000 and there was a divisional investment

of £600,000 with a cost of financing this investment of 15 per cent a year Theresidual income would be as follows:

A positive RI, as in Example 10.2, means that the division is generating returns inexcess of the minimum requirements of the business The higher these excess returns,the better the performance of the division

Does this measure seem familiar to you? Where have we discussed a similar measure

to this earlier in the book?

This measure is based on the same idea as the EVA®

measure that we discussed inChapter 9 We shall consider this point in more detail a little later in the chapter

addi-The residual income for last year is:

Charge for additional capital

Activity 10.11

Looking to the longer term

A problem of both ROI and RI is that divisional managers may focus on short-termdivisional performance at the expense of the longer term There is a danger that investment opportunities will be rejected because they reduce short-term ROI and

RI, even though over the longer term they have a positive NPV This is illustrated inExample 10.3

A division is faced with an investment opportunity that will require an initialinvestment of £90,000 and produce the following operating cash flows (operatingprofit before depreciation) over the next five years:

Assuming a cost of capital of 16 per cent a year, the NPV of the project will be:

Year Cash flows Discount factor Present value

This indicates that the NPV is positive and, therefore, it would be in the holders’ interests to undertake the project

share-To calculate ROI and RI, we need to derive the divisional profit for each year(that is, deduct a charge for depreciation from the operating cash flows shownabove) Assuming that depreciation is charged equally over the life of the assetsacquired and there is no residual value for the assets, the annual depreciationcharge will be £18,000 (that is, £90,000/5)

After deducting an annual depreciation charge, the divisional profit for eachyear will be as follows:

Various approaches have been proposed in an attempt to avoid the kind of problemdescribed above It has been suggested, for example, that for the purpose of calculatingdivisional ROI and RI, the assets employed in the project should not be included in thedivisional investment base until the project is fully established and generating goodreturns

Calculate the ROI and RI for each of the five years of the project’s life (Base the ROI calculation on the cost of the assets concerned.)

The ROI for the project will be as follows:

The RI will be as follows:

Year Divisional profit Capital charge RI

What do you deduce from the calculations resulting from Activity 10.12?

We can see that, in the early years, the ROI and RI calculations do not produce goodresults, though the situation is reversed in later years For the first two years the ROI is zero and for the first three years the RI is negative Divisional managers may, therefore,

be discouraged from making investments if they feel that central management would viewthe results in the early years unfavourably Given the results of the NPV analysis, however,the managers would not be acting in the shareholders’ best interests in rejecting the proposal

Note, however, that the RI of the project overall is positive and so provides a result that

is consistent with the NPV result, over the five years

Activity 10.13

Comparing performance

Assessing divisional performance requires some benchmark against which we can compare the chosen measure(s) There are various bases for comparison available,including:

l Other divisions within the business Comparing different divisions within the same

business, however, may not be very useful where the divisions operate in differentindustries Different types of industries have different levels of risk and this in turnproduces different expectations concerning acceptable levels of return (See pp 270 –

272 in Chapter 8.)

l Previous performance of the division It is possible to compare current performance

with previous performance to see whether there has been any improvement or deterioration However, it is often necessary to compare performance against someexternal standard in order to bring to light operating inefficiencies within the divi-sion Also, the economic environment in previous periods may be different from thecurrent environment and so may invalidate comparisons of this nature

l Similar businesses within the same industry The performance of similar divisions of

other businesses, or whole businesses operating within the same industry, may vide a useful basis for comparison However, there are often problems associatedwith this basis We shall come back to this in Activity 10.14

pro-l Budgeted (target) performance This should be the best basis for comparison because

achievement of the budget should lead the division, and the business as a whole,towards its strategic objectives In setting the budget, performances elsewhere in thebusiness, previous levels of performance by the division and the performance ofcompetitors may well be considered Ultimately, however, it is against what the division has planned for that its actual performance should be assessed

What problems are we likely to come across, in practice, when seeking to compare the performance of a particular division with a similar division of another business, or a whole business entity?

We may encounter a number of problems such as:

l Obtaining the information required This is particularly true for a division within another

business This information may not be available to those outside the business

l Differences in accounting policies Different approaches to such matters as depreciation

methods and inventories valuation methods may result in different measures of profit

l Differences in asset structure The different age of non-current assets employed, the

decision to rent rather than buy particular assets and so on, may result in differences inthe measures derived

Activity 10.14

EVA ® REVISITED 383

measures the amount of wealth that hasbeen created for the owners (shareholders) We may recall that it is based on the following formula:

EVA® revisited

where

R= required returns of investors (that is, cost of financing)

C= capital invested (that is, the net assets)

This measure, though not specifically designed for assessing divisional performance,may nevertheless be used for this purpose

terms, profit can only be said to have been made after all costs, including financingcosts, have been taken into account Hence, a charge for capital invested should bemade When comparing the two measures, it is tempting to think that there is no real

equation (net operating profit after tax, required returns of investorsand net assets) are defined more clearly and in such a way that there is an unambigu-

Real World 10.4provides some insights as to what senior managers consider ant when evaluating the performance of divisional managers It seems that, whatever

, it is not widely used for this purpose

REAL WORLD 10.4

Ranking the measures

In their survey of senior financial managers of 124 divisionalised businesses within themanufacturing sector, referred to in Real World 10.3, Drury and El-Shishini asked the managers to rank in order of importance the three measures that they considered mostimportant for evaluating managerial performance The results are set out below

Financial measure Most Second most Third most

important important important ranking ranking ranking Managers Managers Managers Number % Number % Number %

l Achievement of a target rate of return on capital

l A target profit after charging interest on

l A target profit before charging interest on

We can see that target profit before charging interest on capital employed was by far the

most popular measure Although ROI and RI are well-known measures, neither were quently cited as the most important measure by senior financial managers The limitedsupport for target EVA®

fre-may be partially due to the fact that it is a relatively new measure

Source: Drury, C and El-Shishini, E., ‘Divisional performance measurement: an examination of potential explanatory factors’, CIMA

Research Report, August 2005, p 30.

Andromeda International plc has two operating divisions, the managers of which are givenconsiderable autonomy To assess the performance of divisional managers, senior management uses ROI For the purposes of this measure the assets employed include both non-current and current assets The business has a minimum acceptable ROI of

15 per cent a year and uses the straight-line method of depreciation for external reporting purposes

Extracts from the budgets for each of the two divisions for next year are as follows:

Jupiter division Mars division

1 Senior management would like to see the productivity of the Mars division improve

To help achieve this, they have authorised the divisional manager to buy some newequipment costing £300,000 This will have a life of five years and will lead to operat-ing savings of £90,000 each year

2 A new product can be sold by the Jupiter division This will increase sales revenue by

£250,000 each year over the next five years It will be necessary to increase marketingcosts by £60,000 a year and inventories held will increase by £90,000 The contributionmargin ratio (that is, contribution to sales revenue × 100%) for the new product will be

30 per cent

Required:

(a) Calculate the expected ROI for each division assuming:

1 the investment opportunities are not taken up,

2 the investment opportunities are taken up

(b) Comment on the results obtained in (a) and state how the divisional managers andsenior managers might view the investment opportunities

(c) Discuss the implications of using net book value (that is, after accumulated tion) rather than gross book value (that is, before accumulated depreciation) as a basisfor valuing non-current assets when calculating ROI

deprecia-The answer to this question can be found in Appendix B at the back of the book.

Self-assessment question 10.1

EVA ® REVISITED 385

Sometimes, a division will sell goods or services to another division within the samebusiness For example, a brick-manufacturing division may sell its products to a house-building division The price at which transfers between divisions are made can be animportant issue Setting prices for inter-divisional trading is known as transfer pricing.For the division providing the goods or service, transfers represent part, or possibly all,

of its output If the performance of the division is to be measured in a meaningful way,the division should be credited with ‘sales revenue’ for these goods or services trans-ferred Failure to do so would mean that it would have to bear the expenses of creatingthe goods or service, but would receive no credit for doing so By the same token, thereceiving (buying) division needs to be charged with the expense of using the goods orservice supplied by the other division, if its performance is to be measured in anymeaningful way

Where inter-divisional transfers represent a large part of the total sales or purchases

of a division, transfer pricing is a very important issue Small changes in the transferprice of goods or services can result in large changes in profits for the division con-cerned As divisional managers are often assessed (and partially remunerated) accord-ing to the profits generated by their division, setting transfer prices may be a sensitiveissue between divisional managers

Whilst the particular transfer prices used will affect the profits of individual sions, the profits of the business as a whole should not be directly affected An increase

divi-in the transfer price of goods or services will lead to an divi-increase divi-in the profits of theselling division, which is normally cancelled out by the decrease in profits of the buy-ing division However, the transfer prices set between divisions can indirectly lead to aloss of profits to the business as a whole This is because the level at which they are setmay encourage a divisional manager to take actions that would benefit the division butnot the business as a whole For example a divisional manager may choose to buy aparticular product or service from an outside supplier because it is cheaper than theestablished internal transfer price In such a situation, the profits of the business as awhole may be adversely affected

divi-If the internal supplying division is able to sell in the external market

l the same quantity as were bought externally by the buying division; and

l at the same price as the internal division bought at,the business as a whole will not be worse off

Activity 10.15

The objectives of transfer pricing

Transfer pricing may help to achieve various objectives In particular, setting priate transfer prices may help in promoting the following:

appro-l The independence of divisions By allowing divisional managers to set their own

trans-fer prices, and by allowing other divisions to decide whether or not to trade at theprices quoted, the autonomy of individual divisions is encouraged This, in turn,should help motivate divisional managers

l The assessment of divisional performance Inter-divisional sales will contribute to total

revenues for a division, which in turn influence divisional profit Setting an propriate transfer price can, therefore, be important in deriving a valid measure

ap-of divisional prap-ofit for evaluation purposes This should be ap-of value in helping toestablish incentives for, and promoting accountability of, divisional managers

l The optimisation of profits for the business Transfer prices may seek to optimise profits

for the business as a whole For example, a division may be prevented from quoting

a transfer price for goods that will make buying divisions seek cheaper sources ofsupply from outside the business

l The allocation of divisional resources Transfer prices will be important in determining

the level of output for particular goods and services The level of return from divisional sales can be important in deciding on the level of sales and investmentrelating to a particular product, or group of products

inter-l Tax minimisation Where a business has operations in various countries, it may be

beneficial to set transfer prices such that the bulk of profits are reported in divisionswhere the host country has low tax rates However, tax laws operating in manycountries will seek to prevent this kind of profit manipulation

These objectives for transfer pricing are summarised in Figure 10.4

sin-Activity 10.16