Lecture 6- Divisional performance measures

Decentralisation- Delegating [blank_start]authority[blank_end] to [blank_start]subunits[blank_end] of organisation by [blank_start]senior[blank_end] management

In non-divisionalised organisations, organisation as whole is an [blank_start]investment centre[blank_end] & below this level there is [blank_start]functional structure[blank_end] consisting of [blank_start]cost[blank_end] centres & [blank_start]revenue[blank_end] centres

In divisionalised organisations, organisation is divided into separate [blank_start]profit[blank_end] or [blank_start]investment centres[blank_end] & below this level there is [blank_start]functional structure[blank_end] consisting of [blank_start]cost[blank_end] centres & [blank_start]revenue[blank_end] centres

Divisional economic performance can be influenced by many [blank_start]factors[blank_end] beyond [blank_start]control[blank_end] of divisional managers. To evaluate performance of divisional managers, an attempt needs to made to [blank_start]distinguish[blank_end] between [blank_start]economic[blank_end] & [blank_start]managerial[blank_end] performance

To evaluate performance of divisional manager only those items [blank_start]directly controllable[blank_end] by them should be included in divisional [blank_start]managerial performance[blank_end] financial measures. Therefore, this does not include [blank_start]allocations[blank_end] of [blank_start]indirect costs[blank_end] as they cannot be influenced by divisional managers

Return on investment (ROI)- Method of appraising [blank_start]capital investments[blank_end] where [blank_start]average annual profits[blank_end] from project are divided into [blank_start]average investment cost[blank_end], also known as [blank_start]accounting rate[blank_end] of [blank_start]return[blank_end] & [blank_start]return[blank_end] on [blank_start]capital employed[blank_end]

One advantage of return on investment is that it [blank_start]encourages[blank_end] managers to focus on [blank_start]profits[blank_end], & [blank_start]assets[blank_end] required to generate those [blank_start]profits[blank_end]

Another advantage of return on investment is that it can be used to [blank_start]evaluate[blank_end] relative performance of [blank_start]investment centres[blank_end] for business units of different [blank_start]sizes[blank_end]

Third advantage of return on investment is that it promotes an [blank_start]understanding[blank_end] of [blank_start]relationship[blank_end] between [blank_start]revenues[blank_end], [blank_start]costs[blank_end] & [blank_start]assets[blank_end]

One disadvantage of return on investment is that it [blank_start]encourages[blank_end] managers to focus on [blank_start]short-term[blank_end] financial performance at expense of [blank_start]long-term[blank_end] viability & competitiveness

Another disadvantage of return on investment is that it [blank_start]encourages[blank_end] managers to [blank_start]defer[blank_end] asset replacement. They act in this way to maintain [blank_start]high ROI[blank_end] & show [blank_start]high performance[blank_end]

Third disadvantage of return on investment is that it [blank_start]discourages[blank_end] managers from [blank_start]investing[blank_end] in projects which are [blank_start]acceptable[blank_end] from [blank_start]organisation’s[blank_end] point of view, but [blank_start]decrease[blank_end] investment centre’s ROI

Residual income- [blank_start]Controllable profit[blank_end] less [blank_start]cost of capital[blank_end] charge on investment [blank_start]controllable[blank_end] by divisional manager

One advantage of residual income is that it takes account of organisation’s [blank_start]required rate of return[blank_end] in measuring [blank_start]performance[blank_end] & therefore more likely to promote [blank_start]goal congruence[blank_end], compared to [blank_start]ROI[blank_end]

Another advantage of residual income is that it [blank_start]encourages[blank_end] investment in projects which yield [blank_start]positive residual income[blank_end] to organisation

One disadvantage of residual income is that it is an [blank_start]absolute[blank_end] monetary measure which means it is [blank_start]difficult[blank_end] to compare performance of [blank_start]division[blank_end] with that of other [blank_start]divisions[blank_end] or companies of different [blank_start]size[blank_end], unlike ROI

Another disadvantage of residual income is that formula is [blank_start]biased[blank_end] in [blank_start]favour[blank_end] of [blank_start]larger[blank_end] businesses, unlike [blank_start]ROI[blank_end]

Third disadvantage of residual income is that it can encourage [blank_start]short-term orientation[blank_end]/[blank_start]focus[blank_end], as with [blank_start]ROI[blank_end]

Economic value added- Refinement of [blank_start]residual income[blank_end] measure that incorporates [blank_start]adjustments[blank_end] to divisional financial performance measure for [blank_start]distortions[blank_end] introduced by generally accepted [blank_start]accounting principles[blank_end]

One advantage of economic value added is that it removes [blank_start]distortions[blank_end] that arise when measuring [blank_start]profit[blank_end] based on [blank_start]GAAP[blank_end]

One disadvantage of economic value added is that it is an [blank_start]absolute monetary measure[blank_end]

To measure managerial performance only [blank_start]controllable profits[blank_end] & [blank_start]assets[blank_end] should be included whereas to measure economic performance [blank_start]all profits[blank_end] & [blank_start]assets[blank_end] should be included

Three approaches that can be used to reduce dysfunctional consequences of short-term financial measures are use of [blank_start]financial[blank_end] measures such as [blank_start]economic value added[blank_end], [blank_start]lengthening[blank_end] performance measurement [blank_start]period[blank_end] & focusing on both [blank_start]financial[blank_end] & [blank_start]non-financial[blank_end] measures using [blank_start]balance scorecard[blank_end]