Tools for Business Decision Management Makers_11 docx

CHAPTER 10 MEASURING PERFORMANCE 372 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 strategic objectives 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 performance measures that can help assess both the division and its divisional managers. It is to this challenge 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 divisional income 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 divisional managers, it is important for them to appreciate that they are not operating completely independent units and that divisional managers also have responsibilities towards the business 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 risk provided 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 of budget 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. Divisional managers would then be accountable only for the variances within their control. It is not always easy, however, to obtain unbiased information for preparing budgets from divisional managers 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 of divisional 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 any signs that divisional managers are rewarding themselves in this way. Duplication of effort in certain areas can be extremely costly. For this reason, some businesses prefer particular functions, such as administration, accounting, research and development and marketing, to be undertaken by central staff rather than at the divisional level. Again, this means that divisional managers will have to sacrifice some autonomy for the sake of the performance of the business overall. Activity 10.2 continued M10_ATRI3622_06_SE_C10.QXD 5/29/09 10:41 AM Page 372 Household Appliances Divisional Income Statement for last year £000 Sales revenue 980 Variable expenses (490) Contribution 490 Controllable divisional fixed expenses (130) Controllable profit 360 Non-controllable divisional fixed expenses (150) Divisional profit before common expenses 210 Apportioned cost of common expenses (80) 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 the divisional manager to exert an influence over particular expenses. Thus, an expense that is authorised by a senior manager at head office will not be under the control of the divisional manager, despite the fact that the expense may relate to the division. An expense that arises directly from a decision taken by the divisional manager, on the other hand, is controllable at divisional level. As is implied by this income statement for the division, there are four measures of profit that could be used to assess performance. These are: contribution; controllable profit; 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 considered this measure at length in Chapter 3. There we saw that it can be a useful measure for gaining 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. This means 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 are ignored, it would be tempting to arrange things so that fixed expenses rather than variable expenses 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 to use machines to do the work instead (even though this may be a more expensive option). Activity 10.4 MEASURING DIVISIONAL PROFIT 373 M10_ATRI3622_06_SE_C10.QXD 5/29/09 10:41 AM Page 373 CHAPTER 10 MEASURING PERFORMANCE 374 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 costs or non-controllable costs. Some expenses may be capable of being influenced by divisional 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 informa- 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 is replaced, as well as over the purchase of particular hardware models that perform beyond 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 if the 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 the overall 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 the basis of those things that are within their control. Hence, the controllable profit would be the most appropriate measure to use. The contribution measure does not take account of all the expenses that are controllable by divisional managers, whilst the divisional profit before common expenses takes account of some expenses that are not under the control of divisional managers. The latter measure, however, may be appropriate for evaluating the performance of the division, as it deducts all divisional expenses from the divisional revenues 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 expenses apportioned to each division will presumably represent what central management believes 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 ‘ ‘ M10_ATRI3622_06_SE_C10.QXD 5/29/09 10:41 AM Page 374 way that these apportionments are made between divisions can be extremely conten- tious. Some divisional managers may be convinced that they have been apportioned an unfair share of the common expenses. They may also believe that the divisions are being loaded with expenses over which they have little control and that the divisional profit figure derived will not truly represent the achievements of the division. These are often compelling arguments for not apportioning common expenses to the various divisions. 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 cov- ered. Apportioning these expenses to the divisions should help make divisional managers more aware of this fact. In addition, top management may wish to compare the results of the division with the results of similar businesses in the same industry that are operating as independent entities. By apportioning common expenses to the divisions, a more valid basis 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. Divisional managers may put pressure on top managers to keep common expenses low so as to minimise the adverse effect on divisional profits. Activity 10.6 Real World 10.3 sheds some light on the amount of common expenses assigned to divisions. REAL WORLD 10.3 Something in common Drury and El-Shishini conducted a survey of 124 senior financial managers of divisionalised businesses within the manufacturing sector. They found that nearly all managers (95 per cent) stated that the divisions used common resources such as marketing, personnel, accounting and so on. The survey asked those managers to state the approximate cost of using these resources as a percentage of annual divisional sales revenue. Figure 10.3 sets out the findings. We can see that the costs of using common resources tend to be fairly low. The rea- sons for this are not entirely clear. One possible explanation is that highly decentralised businesses tend to have divisions that are self-reliant. Hence, the level of dependence on common resources will be low. Another possible explanation is that businesses with a large number of divisions have a greater opportunity to spread the costs of common resources among the various divisions. The study found, however, little or no evidence to support these explanations. MEASURING DIVISIONAL PROFIT 375 ‘ M10_ATRI3622_06_SE_C10.QXD 5/29/09 10:41 AM Page 375 CHAPTER 10 MEASURING PERFORMANCE 376 Divisional profit, by itself, is an inadequate measure of divisional performance. Some account must be taken of the investment in assets required to generate that profit. Two well-established measures of divisional performance that do this are l return on investment (ROI), and l residual income (RI). 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 of divisions. The ratio is calculated in the following way: ROI == ×× 100% 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. M10_ATRI3622_06_SE_C10.QXD 5/29/09 10:41 AM Page 376 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-current assets 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 are used, there is absolute consistency. It could be very misleading to try to compare the ROIs of two different divisions using one set of definitions for one division and another set for the other division. The ROI ratio can be broken down into two main elements. These are: ROI =× 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 to generate a high level of sales revenue in relation to the investment base. Sales revenue Divisional investment Divisional profit Sales revenue The following data relate to the performance and position of two operating divisions that sell similar products: Kuala Lumpur Singapore Division Division £000 £000 Sales revenue 300 750 Divisional profit 30 25 Divisional investment 600 500 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 and 25/500). 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 per cent (that is, 30/300) and 3.3 per cent (that is, 25/750) respectively. The sales revenue to divisional 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 that the Kuala Lumpur Division prefers to sell goods at a higher profit margin than the Singapore 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 differ- ent sizes. However, ROI has its drawbacks. Where it is used as the primary measure of performance for divisional managers, there is a danger that it will lead to behaviour that is not really consistent with the interests of the business overall. DIVISIONAL PERFORMANCE MEASURES 377 Russell Francis plc has two divisions, both selling similar products but operating in dif- 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. Activity 10.8 ‘ M10_ATRI3622_06_SE_C10.QXD 5/29/09 10:41 AM Page 377 CHAPTER 10 MEASURING PERFORMANCE 378 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 charged each 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 the lifetime 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-year period: Year Divisional Divisional ROI at net profit investment book value ££% 1 30,000 200,000 15.0 2 30,000 180,000 16.7 3 30,000 160,000 18.8 4 30,000 140,000 21.4 The investment is an item of equipment that cost £200,000 at the beginning of Year 1. It is being depreciated at the rate of 10 per cent of cost each year. Example 10.1 The divisional manager of each division has the opportunity to invest £200,000 in the development of a new product line that will boost controllable profit by £50,000. The minimum acceptable ROI for each division is 16 per cent a year. 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 the Sussex 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 divisional manager 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 reflect poorly 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 exploit the 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 M10_ATRI3622_06_SE_C10.QXD 5/29/09 10:41 AM Page 378 Residual income (RI) The weaknesses of the ROI method, particularly the fact that it ignores the cost of financing a division, has led some businesses to search for a more appropriate measure of divisional performance. An alternative measure is that of residual income (RI). RI is the amount of income, or profit, generated by a division, which is in excess of the min- imum acceptable level of income. If we assume that the objective of the business is to increase owners’ (shareholders’) wealth, the minimum acceptable level of income to be generated is the amount necessary to cover the cost of capital. Taking the divisional profit figure and then deducting an imputed charge for the capital 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 as much profit. We saw above that divisional managers may be discouraged from investing 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 to replace 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 the existing 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 cost and not to deduct depreciation for purposes of calculating ROI. However, non-current assets normally lose their productive capacity over time, and this fact should really be recognised. Another way around the problem is to use some measure of current market value, such as replacement cost, for the investment in assets. However, there may be problems 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. The residual income would be as follows: £ Divisional profit 100,000 Charge for capital invested (15% × £600,000) (90,000) Residual income 10,000 Example 10.2 DIVISIONAL PERFORMANCE MEASURES 379 ‘ M10_ATRI3622_06_SE_C10.QXD 5/29/09 10:41 AM Page 379 CHAPTER 10 MEASURING PERFORMANCE 380 A positive RI, as in Example 10.2, means that the division is generating returns in excess 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 in Chapter 9. We shall consider this point in more detail a little later in the chapter. Activity 10.10 Simonson Pharmaceuticals plc operates the Helena Beauty Care Division, which has reported the following results for last year: Divisional investment £2,000,000 Divisional profit £300,000 The division has the opportunity to invest in a new product. This will require an addi- tional investment in non-current assets of £400,000 and is expected to generate addi- tional profits of £50,000 a year. This business has a cost of capital of 12 per cent a year. Try calculating the residual income of the division for last year. Do you believe that the division should produce the new product? How do you think that the divisional manager might react to the new product opportunity if ROI were used as the means of evaluating performance? The residual income for last year is: £000 Divisional profit 300 Charge for capital invested (12% × £2,000,000) (240) Residual income 60 The residual income expected from the new product is: £000 Additional divisional profit 50 Charge for additional capital (12% × £400,000) (48) Residual income 2 The residual income is positive and, therefore, it would be worthwhile to produce the new product. The ROI of the division for last year was 15 per cent a year (that is, £300,000/£2m). However, the new product is only expected to produce an ROI of 12.5 per cent a year (that is, £50,000/£400,000). The effect of producing the new product will be to reduce the overall ROI of the division (assuming similar results from the existing activities next year). The divisional manager may, therefore, reject the new investment opportunity, despite the fact that acceptance would enhance the owners’ (shareholders’) wealth. The new product would cover all of the costs, including the cost of financing the investment. Activity 10.11 M10_ATRI3622_06_SE_C10.QXD 5/29/09 10:41 AM Page 380 Looking to the longer term A problem of both ROI and RI is that divisional managers may focus on short-term divisional 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 in Example 10.3. A division is faced with an investment opportunity that will require an initial investment of £90,000 and produce the following operating cash flows (operating profit before depreciation) over the next five years: Year £ 1 18,000 2 18,000 3 25,000 4 50,000 5 60,000 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 £ @ 16% £ 1 18,000 0.862 15,516 2 18,000 0.743 13,374 3 25,000 0.641 16,025 4 50,000 0.552 27,600 5 60,000 0.476 28,560 101,075 Initial investment (90,000) Net present value 11,075 This indicates that the NPV is positive and, therefore, it would be in the share- holders’ interests to undertake the project. 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 shown above). Assuming that depreciation is charged equally over the life of the assets acquired and there is no residual value for the assets, the annual depreciation charge will be £18,000 (that is, £90,000/5). After deducting an annual depreciation charge, the divisional profit for each year will be as follows: Year £ 1 zero 2 zero 3 7,000 4 32,000 5 42,000 Example 10.3 DIVISIONAL PERFORMANCE MEASURES 381 M10_ATRI3622_06_SE_C10.QXD 5/29/09 10:41 AM Page 381 [...]... short term RI is generally considered a better performance indicator than ROI Assessing divisional performance requires some basis for comparison A particular division can be compared with that for: – Other divisions of the same business – Previous performance of the same division – Performance of businesses in the same industry as the division – Budgeted performance – probably the best basis of comparison... 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 of supply from outside the business The allocation of divisional resources Transfer prices will be important in determining the level of output for particular goods... 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 l 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 Differences in accounting policies... 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... the budget should lead the division, and the business as a whole, towards its strategic objectives In setting the budget, performances elsewhere in the business, previous levels of performance by the division and the performance of competitors may well be considered Ultimately, however, it is against what the division has planned for that its actual performance should be assessed Activity 10.14 What... exclusively on short-term financial performance measures, such as sales revenues and profits, these measures become the main focus of attention As a result, decisions may be made to enhance these reported performance measures, and other aspects of the business may be ignored The result is likely to be to the detriment of the business For example, to increase annual profit a decision may be made to cut back... 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 provide a useful basis for comparison However, there are often problems associated with this basis We shall come back to this in Activity 10.14 l Budgeted (target) performance This should be the best basis for comparison because... costs of the business as a whole To prevent this problem from occurring, the following transfer pricing guidelines are in place: l l l transfer prices for goods and services transferred from unregulated businesses to regulated ones should be at market price or less; regulated businesses should market test to determine the market prices for works or services to be transferred to unregulated businesses;... two different transfer prices It may be that setting the buying price, for the buying division, at one value and the selling price, for the selling division, at a different value, could lead to both divisions being encouraged to act in the best interests of the business as a whole This would mean that the overall profit for the business would not equal the sum of the profits of the individual divisions,... government regulator, Ofwat, must therefore be assured that any transactions between the regulated water and sewerage activities and other unregulated businesses are not to the disadvantage of customers of the regulated activities If, for example, water or sewerage services were charged to other unregulated businesses at a price below cost, or services bought in from other businesses were charged at a price . 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. Similar businesses within the same industry. The performance of similar divisions of other businesses, or whole businesses operating within the same industry, may pro- vide a useful basis for comparison 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.