Divisional Performance Assessment

Question 1

why divisionalise

Answer 1

Orgs divisionalise to get access geographically. different markets have their divisions
product based - to sell different products

Reasons include
- orgs may be different to manage
- career progression for staff
- legal requirements in different countries
- specialisation - diversified companies have different products so a single managing board will not be effective.

Question 2

Performance mgt issues in divisionalised businesses - Agency Risk, controllability of costs

Answer 2

Problems include

1. Agency risk - Divisional manager will act in their own best interest rather than interest of wider group. The key issue is goal congruence
   Areas affected might be
   - Project A v project B - DM wants a different project to HO
   - Transfer pricing - Choosing to buy from outside the group because
   it is cheaper but group has free resources to produce
   - Resource management - using freelancers instead of group
   employees
2. Controllability of costs - This mainly affects head office costs allocated to divisions. e.g. IT, HR, finance.
   When assessing performance costs incurred must be controllable for process to be fair and reasonable.

Head office costs are traceable to the divisions but not controllable
divisional profit margin = controllable profit should be used but total investment performance can use net profit as they are traceable.
lack of separation of head office costs is a major source of irritation and demoralisation for divisional managers

Question 3

Performance mgt issues in divisionalised businesses - Dysfunctional behaviour, Interdependency, performance measurement

Answer 3

3. Dysfunctional behaviour - Business cannot rely on manager to act in best interest of business. they may actin their best interest.
   A short-termist manager will pick a project with more short term profits over a projects with better cashflow in the long run.
4. Interdependency - The results of a division may be impacted by the actions of another division e.g. client relationship is damaged by one region affecting another.
5. Performance measurement - the methods of performance measurement should be different for cost centres, profit centres and investment centres (controls assets & purchases).

cost centre - Cost budgets and variances, cost ratios, VFM
Profit centre - all above , revenue budgets and variances, margins, profitability
Investment centre - all above, ROI, RI,EVA.

Question 4

Return on investment - formula, adv, drawbacks

Answer 4

ROI = controllable profit / controllable capital employed

• controllable profits excludes HO costs
  *Controllable capital employed excludes assets e.g. receivables

Capital employed = long term debt plus equity /NCA+CA-CL

ROI is compared to ROI given in plan or external environment

Adv
1. simple to calculate
2. figures should be readily available
3. result should be comparable to other divisions of same sizes
4. shows a return relative to asset investment

Measurement drawbacks
1. can encourage assets to be held for too long leading poor quality work or shoddy appearance.
2. can produce a misleading picture of performance with a gradual and almost inevitable increase of ROI as the asset ages.
3. If ROI is used for decision making it can lead to dysfunctional decision making

Question 5

Residual Income - formula, adv, drawbacks

Answer 5

Controllable profit X
less: imputed interest charge on assets (X)
Residual income

A positive RI is good performance

Adv
1. simple to calculate
2. figures readily available
3. finance cost is highlighted to divisional managers
4. Result is an absolute measure showing how much money has been made compared to cost of money return
5. RI is marginally less dysfunctional than ROI since there will be consistency between preferences of had office and divisional managers

drawbacks
1. same as ROI

Overall conclusions
1. Dysfunctional decision making
2. Retention of aging assets
3. Misleading performance data