17. Divisional Performance Evaluation

Question 1

What is decentralization?

Answer 1

The delegation of authority to make decisions.

Question 2

Differentiate between the following centres:
1. Revenue
2. Cost
3. Profit
4. Investment

Answer 2

Revenue centres - managers are responsible for decisions about revenue generation (usually including selling costs).

Cost centres - managers are responsible for decisions about costs.

Profit centres - managers are responsible for decisions about costs and revenues.

Investment centres - managers are responsible for decisions about cost and revenues and investments in assets.

Question 3

List 6 benefits of decentralisation.

Answer 3

1. Senior management can concentrate on strategy - delegating routine decisions frees senior management for long-term corporate planning.
2. Faster decision making - divisional managers are “on the spot” and can react quickly to changes.
3. Better decision making - specialist managers are likely to understand their part of the business better than senior management.
4. Motivation - divisional managers are given responsibility and status and may increase effort.
5. Training and career progression - divisional managers acquire skills and experience which may prepare them for senior management (e.g. managers may be “rotated” between divisions).
6. Tax advantages - locating divisions in certain areas which enjoy tax incentives or government grants.

Question 4

What are 4 problems associated with decentralisation?

Answer 4

1. Lack of goal congruence - risk that divisional managers will make decisions not consistent with overall organisational objectives.
2. Increased information requirements - reporting systems must be introduced to monitor divisional performance.
3. Lost economies of scale - costs may rise through duplication of activities. A central purchasing department may achieve better prices and lower overall overhead than divisional purchasing departments. (Think shared services)
4. Loss of central control - top management loses control to divisional managers. Conflict may occur if top management disagrees with the decisions of divisional managers.

Question 5

What are the four conditions for successful decentralisation?

Answer 5

1. Carefully designed performance evaluation systems to reduce the risk of dysfunctional decisions.
2. Business has several separate activities.
3. Central policies to integrate and control (e.g. major capital expenditure, strategic decisions and transfer prices).
4. Divisions should be independent from each other.

Question 6

What are dysfunctional decisions?

Answer 6

Managers make decisions that are not in the best interests of the overall company. This is a risk of decentralisation.

Question 7

A good performance evaluation system should provide for 3 things. What are these three things?

Answer 7

1. Goal congruence - performance measures should encourage decisions consistent with company objectives.
2. Timeliness - performance reporting must be fast enough to allow required corrective action.
3. Controllability - evaluation should assess only divisions and divisional managers on performance under their control.

Question 8

Differentiate between controllable profit and traceable profit.

Answer 8

Controllable profit is used to assess the manager’s performance and traceable profit is used to assess the division’s performance.

Question 9

What is return on investment?

Answer 9

A return on capital employed which compares income with the operational assets used to generate that income.

Question 10

What are the formulas for ROI for managers and divisions respectively? State the decision rule for ROI

Answer 10

Note: EBIT should be used because interest is affected by financing decisions and tax is an appropriation.

For manager:
ROI = (controllable profit/capital employed) x 100

For division:
ROI = (traceable profit/capital employed) x 100

Decision rule: divisional performance is favourable if ROI is greater than the cost of capital.

Question 11

Investments in capital usual has two components, what are these components?

Answer 11

1. Fixed capital - non-current assets
2. Working capital - net current assets

Question 12

What are 6 advantages of ROI?

Answer 12

1. As a relative measure, it is easy to compare divisions. Ie not absolute.
2. Similar to ROCE used externally by analysts.
3. Focuses attention on scarce capital resources.
4. Encourages reduction in non-essential investment by:
   - selling off unused non-current assets
   - minimising the investment in working capital
5. Easily understood percentages (especially by non-financial managers).
6. Can be further analysed (ie between profit margin and asset turnover).

Question 13

What are 4 disadvantages of ROI?

Answer 13

1. Risk of dysfunctional decision making.
2. Decision of capital employed is subjective. For example, should non-current assets be valued using:
   - carrying amount
   - historical cost
   - replacement cost
   Should leased assets and intangible assets be included?
3. If net book value is used, ROI will become inflated over time because of depreciation. This may encourage managers to defer asset replacement.
4. Risk of window-dressing; inflating reported ROI by:
   - under investing and/or
   - cutting discretionary costs (particularly if ROI is linked to bonus systems).

Question 14

What is residual income?

Answer 14

Residual income is the pre-tax profit less imputed interest charge for capital invested.

RI focuses on the creation of wealth. Y deducting an imputed interest expense, which represents the cost of capital invested, from profit.

Question 15

What are the calculations for residual income for managers and divisions? What is the decision rule?

Answer 15

For managers:
RI = controllable profit - imputed interest charge

For divisions:
RI = traceable profit - imputed interest charge

Decision rule - accept a project or investment if the residual income is positive.

Question 16

What is imputed interest and how is it calculated?

Answer 16

Imputed interest is a notional interest charge on the division by the head office.

Imputed interest = capital employed x interest rate

The company’s cost of capital is often used as the basis for the interest rate.

Question 17

What are three advantages of Residual Income?

Answer 17

1. RI overcomes some of the problems associated with ROI (dysfunctional behavior and holding on to old assets).
2. It can be linked to NPV which, theoretically, is the best way to make investment decisions. The PV of an investment’s RI equals the investment’s NPV. In the long run, companies that maximize their RI will also maximise their NPV and in turn shareholder wealth.
3. A risk-adjusted cost of capital can be used to reflect different risk positions of different divisions.

Question 18

What are 5 disadvantages of using residual income as a performance measure?

Answer 18

1. Definition of capital employed.
2. Effect of depreciation.
3. Window dressing.
4. It is difficult to compare divisions of different sizes. The manager of the larger division will generally show a higher RI because of the size of the division rather than superior managerial performance.
5. Less easily understood than a percentage.