The evaluation of new capital expenditure proposals is a key element in allocating resources by the whole organization. However, a further aspect of strategy implementation is improving and maintaining divisional performance. This post describes the methods by which the performance of divisions and their managers is evaluated. It also considers controllability and suggests that some techniques may provide an appearance rather than the reality of “rational” financial [and business] decision-making.
The Decentralized Organization And Divisional Performance Measurement
Businesses may be organized in a centralized or decentralized manner. The centralized business is one in which most decisions are made at a head office level, even though the business may be spread over a number of market segments and geographically diverse locations. Decentralization implies the devolution of authority to make decisions. Divisionalization adds to decentralization the concept of delegated profit responsibility (Solomons, 1965).
Divisionalization makes it easier for a company to diversify, while retaining overall strategic direction and control. Performance improvement is encouraged by assigning individual responsibility for divisional performance, typically linked to executive remuneration (bonuses, profit-sharing, share options etc.).
Shareholder value is the criterion for overall business success, but divisional performance is the criterion for divisional success. However, divisional performance measurement has also moved beyond financial measures to incorporate the drivers of financial results, i.e. non-financial performance measures.
Solomons (1965) highlighted three purposes for financial reporting at a divisional level:
- to guide divisional managers in making decisions.
- to guide top management in making decisions.
- to enable top management to appraise the performance of divisional management.
The decentralization of businesses has removed the centrality of the head office with its functional structure [marketing, operations, distribution, finance etc.]. Instead, many support functions are now devolved to business units, which may be called subsidiaries [if they are legally distinct entities], divisions, departments etc. For simplicity, we will use the term divisionalization although the same principle applies to any business unit. This divisionalization allows managers to have autonomy over certain aspects of the business, but those managers are then accountable for the performance of their business units. Divisionalized business units may be:
- Cost centre – where managers are responsible for controlling costs within budget limits. Managers are evaluated on their performance compared to budget by keeping costs within budget constraints.
- Profit centre – where managers are responsible for sales performance, achieving gross margins and controlling expenses, i.e. for the “bottom-line” profit performance of the business unit. Managers are evaluated on their performance compared to budget in achieving or exceeding their profit target.
- Investment centre – where managers have profit responsibility but also influence the amount of capital invested in their business units. Managers are evaluated based on a measure of the return on investment made by the investment centre.
Solomons (1965) identified the difficulties involved in measuring managerial performance. Absolute profit is not a good measure because it does not consider the investment in the business and how long-term profits can be affected by short-term decisions such as reducing research, maintenance and advertising expenditure. These decisions will improve reported profits in the current year, but will usually have a detrimental long-term impact. The performance of divisions and their managers can be evaluated using two methods: either return on investment or residual income.
Return on investment
The relative success of managers can be judged by the return on investment. This is the rate of return achieved on the capital employed and was a method developed by the DuPont Powder Company early in the twentieth century. Using ROI, managerial and divisional success is judged according to the rate of return on the investment. However, a problem with this approach is whether a high rate of return on a small capital investment is better or worse than a lower return on a larger capital.
Div A Div B
Capital invested $1,000,000 $2,000,000
Operating profit $200,000 $300,000
Return on investment 20% 15%
Division B makes a higher profit in absolute terms but a lower return on the capital invested in the business. Solomons (1965) also argued that a decision cannot be made about relative performance unless we know the cost of capital.
A different approach to evaluating performance is residual income, which takes into account the cost of capital. Residual income [or RI] is the profit remaining after deducting the notional cost of capital from the investment in the division. The RI approach was developed by the General Electric Company and more recently has been compared with Economic Value Added [EVA], as both methods deduct a notional cost of capital from the reported profit.
Using the above example:
Div A Div B
Capital invested $1,000,000 $2,000,000
Operating profit $200,000 $300,000
less cost of capital at 17.5% $175,000 $350,000
Residual income $25,000 -$50,000
As the cost of capital is 17.5% in the above example, Division A makes a satisfactory return but Division B does not. Division B is eroding shareholder value while Division A is creating it.
The aim of managers should be to maximize the residual income from the capital investments in their divisions. However, Solomons (1965) emphasizes that the RI approach assumes that managers have the power to influence the amount of capital investment. Solomons argued that an RI target is preferred to a maximization objective because it takes into account the differential investments in divisions, i.e. that a larger division will almost certainly produce – or should produce – a higher residual income.
Johnson and Kaplan (1987) believe that the residual income approach:
…overcame one of the dysfunctional aspects of the ROI measure in which managers could increase their reported ROI by rejecting investments that yielded returns in excess of their firm’s (or division’s) cost of capital, but that were below their current average ROI.
One of the main problems in evaluating divisional performance is the extent to which managers can exercise control over investments and costs charged to their responsibility centre.
The principle of controllability, according to Merchant (1987, p. 316), is that “individuals should be held accountable only for results they can control“. One of the limitations of operating profit as a measure of divisional performance is the inclusion of costs over which the divisional manager has no control. The need for the company as a whole to make a profit demands that corporate costs be allocated to divisions so that these costs can be recovered in the prices charged.
The problem arises when a division’s profit is not sufficient to cover the head office charge. Solomons (1965) argued that so long as corporate expenses are independent of divisional activity, allocating corporate costs is irrelevant because a positive contribution by divisions will cover at least some of those costs.
Solomons separated these components in the divisional profit report, a simplified version of which is shown below:
Sales = $$$
Less: – Variable cost of goods sold = $$$
– Other variable expenses = $$$
Contribution margin = $$$
Less:- Controllable divisional overhead = ($$$)
Controllable profit = $$$
Less:- Non-controllable overhead = ($$$)
Operating profit = $$$
While the business as a whole may consider the operating profit to be the most important figure, performance evaluation of the manager can only be carried out based on the controllable profit. The controllable profit is the profit after deducting expenses that can be controlled by the divisional manager, but ignoring those expenses that are outside the divisional manager’s control. What is controllable or non-controllable will depend on the circumstances of each organization. Solomon argued that the most suitable figure for appraising divisional managers was the controllable residual income before taxes. Using this method, the controllable profit is reduced by the corporate cost of capital. For decisions in relation to a division’s performance, the relevant figure is the net residual income after taxes.
One of the problems with both the ROI and RI measures of divisional performance is the calculation of the capital investment in the division: should it be total [i.e. capital employed] or net assets [allowing for gearing]? Should it include fixed or current assets, or both? Should assets be valued at cost or net book value? Should the book value be at the beginning or end of the period? Solomons (1965) argued that it was the amount of capital put into the business, rather than what could be taken out, that was relevant. The investment value, according to Solomons, should be total assets less controllable liabilities, with fixed assets valued at cost using the value at the beginning of the period. ROI calculations therefore relate controllable operating profit as a percentage of controllable investment. An RI approach would measure net residual income plus actual interest expense (because the notional cost of capital has been deducted in calculating RI) against the total investment in the division.