Entity Organisation and Performance Measurement Flashcards
ORGANISATIONAL STRUCTURE
Starts at the highest level of authority, usually the owners, and then responsibility cascades down through the various organisational levels.
There will be responsible managers with defined duties and accountability towards particular performance measures.
DECENTRALISATION
The more the responsibility is passed downwards and outwards to other people, the more we say an organisation is decentralised.
Decentralisation becomes a major issue for global organisations, including multinationals, which have subsidiaries in different countries all over the world.
To what extent should subsidiary units be handed over local responsibility?
DIVISIONALISATION
Large organisations are split into different divisions based on products/services, brands and markets.
A division is responsible for contributing to the profitability of the company as a whole.
CHALLENGE:
- Delegation of decision-making to divisional managers.
- Retention of overall control by head over.
What are the advantages of divisionalisation?
- Improve quality of decisions.
- Speedier decisions.
- Greater freedom to divisional managers, which motivates them to make their activities more challenging and provides them with opportunities to achieve self fulfilment.
- Enables top management to devote more time to strategic issues.
What are the disadvantages of divisionalisation?
- More costly to operate.
- Loss of control by top management.
- May promote a lack of goal congruence:
- Divisions may compete with one another excessively.
- Divisional managers may be encouraged to take action that will increase their own profits at the expense of the profits of other divisions and the company as a whole.
When is divisionalisation successful?
- More appropriate for companies with diversified/dissimilar activities.
- The activities of a division should be as independent as possible of other divisions’ activities.
- No division, by seeking to increase its own profit, should reduce the profitability of the company as a whole.
- Divisions should contribute not only to the success of the company but to the success of one another.
RESPONSIBILITY CENTRES
A responsibility centre is a unit of an organisation where the manager is held accountable for the unit’s activities and performance.
COST CENTRE
A location to which costs are assigned.
PROFIT CENTRE
A division of an organisation in which the manager does not control the investment and is responsible only for the profits obtained from operating the assets assigned by corporate headquarters.
INVESTMENT CENTRE
Responsibility centre whose managers are responsible for both sales revenues and costs and also have responsibility and authority to make capital investment decisions.
In non-divisionalised organisations, the organisation as a whole is an investment centre.
FINANCIAL MEASURES
Fundamental component for management control and performance measurement of divisional organisations.
They need to be supplemented by non-financial measures.
Accounting measures: revenues, costs, profit, return on assets, etc.
RETURN ON INVESTMENT
Divisional profit as a percentage of the assets employed in the division.
= profit/investment
ADVANTAGES OF RETURN ON INVESTMENT
- Combines revenues, costs and investments.
- It is a percentage, therefore it enables comparing the profitability of divisions of different size, divisions in different industries, competitors and different types of investments.
How is an investment decision made when using ROI
Criterion: invest if ROI > Cost of Capital
EXPLANATION:
If divisional ROI < opportunity cost of the capital invested in each division then the invested capital would gain a greater return if invested in an alternative use, inside or even outside the company.
COST OF CAPITAL
A composite of the cost of various sources of funds comprising a firm’s capital structure.
What are the potential problems of RoI?
- Divisional managers may adopt decisions that improve RoI of their division but make the company worse off, and vice versa.
- Promotes myopic, short-term behaviour, compromising long term competitiveness and profitability.
- Leads to a lack of goal congruence.
RESIDUAL INCOME
Controllable profit less a cost of capital charge on the investment controllable by the divisional manager.
Generic formula = profit - capital charge
OR
Profit - (investment capital x cost of capital)
Advantages of Residual Income?
Alleviates the lack of goal congruence a bit.
Emphasises cost of capital charge
More flexible that RoI
-Different cost of capital percentage rates can be applied to investments that have different levels of risk.
Limitations of Residual Income?
Absolute value (not a percentage), so it is not suitable to compare divisions of different size. -A large division is more likely to earn a larger RI than a smaller division.
Does not address the myopia problem of RoI.
What two objectives must be distinguished between when choosing financial measures?
- Evaluate the performance of the divisional manager, or
- Evaluate the economic performance of the division.
Divisional economic performance can be influenced by many factors beyond the control of divisional managers.
Evaluation of divisional managerial performance.
Manager’s controllable profit
- Exclude costs directly attributed to the division but the manager does not control
- Exclude the costs incurred at headquarter level which are indirect and are merely allocated among divisions.
Managers controllable (net) assets
- Exclude assets beyond his/her responsibility
- If the manager is also responsible for liabilities, then consider net assets
Evaluation of divisional economic performance.
Include non-controllable costs that could be avoided by closing the division.
All assets supporting division’s operations
- Even if not managed or controllable by the division.
- Even if owned by headquarters and merely allocated to divisions.
CAPITAL INVESTMENT DECISION
Use NPV based on cash flows over the whole life of projects.
Managerial performances are often evaluated using short-term financial measures.
How to reduce dysfunctional consequences of short-term financial measures?
Use improved financial performance, such as EVA.
Lengthen the performance measurement period.
-There is danger that managers might lose their motivations.
Do not rely excessively on accounting measures and incorporate non-finance measures, such as Balance Score Card.
Economic Value Added
EVA: Conventional divisional profit +/- accounting adjustments - capital charge on divisional assets
(WACC x divisional controllable assets)
WEIGHTED AVERAGE COST OF CAPITAL
- WACC reflects the opportunity cost for debt and equity holders, weighted for their relative contribution to a company’s capital structure.
- Minimum economic return a company must generate to compensate its debt and equity security holders for their assumed risk.
Why adjust accounting figures using EVA?
Correct economic measurement distortions that introduced in accounting figures.
Typical EVA adjustments include:
- Capitalisation expenses in intagibles
(e. g. R&D, training, advertising and restructuring, which may not be recognised as assets under GAAP)
Advantages of EVA
- Emphasises cost of capital charge
- Economic perspective
- Reduces the managerial myopia risk of ROI and RI.
Limitations of EVA
- Absolute value so not suitable for comparing divisions of different sizes.
- Cannot totally create an economic measure.
- Does not totally eliminate the myopia bias -> has potential for manipulation and short-term orientation.
- Often considered difficult to understand and expensive to implement.
NET BOOK VALUE
An asset’s historical cost minus accumulated depreciation.
GROSS COST
Historical cost without the reduction for depreciation.
HISTORICAL COSTS (acquisition cost)
Net Book Value
Gross Cost
Current costs (based on economic value or replacement cost)
Replacement cost
Liquidation (realisable value)
REPLACEMENT COST
The current cost to replace the assets at the current level of service and functionality.
LIQUIDATION (REALISABLE) VALUE
The price that could be received from the asset’s sale.
How to measure investment (assets)?
Net book value often preferred (consistent with statement of financial position and profitability calculations)
Potential problems of using net book value:
- Tends to make performance measures improve in time.
- Discourages replacing old, highly depreciated equipment.
- Similar problem across all three measures (RoI, RI and EVA)
