Entity Organisation and Performance Measurement

Question 1

ORGANISATIONAL STRUCTURE

Answer 1

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.

Question 2

DECENTRALISATION

Answer 2

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?

Question 3

DIVISIONALISATION

Answer 3

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.

Question 4

What are the advantages of divisionalisation?

Answer 4

• 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.

Question 5

What are the disadvantages of divisionalisation?

Answer 5

• 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.

Question 6

When is divisionalisation successful?

Answer 6

• 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.

Question 7

RESPONSIBILITY CENTRES

Answer 7

A responsibility centre is a unit of an organisation where the manager is held accountable for the unit’s activities and performance.

Question 8

COST CENTRE

Answer 8

A location to which costs are assigned.

Question 9

PROFIT CENTRE

Answer 9

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.

Question 10

INVESTMENT CENTRE

Answer 10

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.

Question 11

FINANCIAL MEASURES

Answer 11

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.

Question 12

RETURN ON INVESTMENT

Answer 12

Divisional profit as a percentage of the assets employed in the division.

= profit/investment

Question 13

ADVANTAGES OF RETURN ON INVESTMENT

Answer 13

• 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.

Question 14

How is an investment decision made when using ROI

Answer 14

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.

Question 15

COST OF CAPITAL

Answer 15

A composite of the cost of various sources of funds comprising a firm’s capital structure.

Question 16

What are the potential problems of RoI?

Answer 16

• 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.

Question 17

RESIDUAL INCOME

Answer 17

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)

Question 18

Advantages of Residual Income?

Answer 18

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.

Question 19

Limitations of Residual Income?

Answer 19

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.

Question 20

What two objectives must be distinguished between when choosing financial measures?

Answer 20

• 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.

Question 21

Evaluation of divisional managerial performance.

Answer 21

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

Question 22

Evaluation of divisional economic performance.

Answer 22

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.

Question 23

CAPITAL INVESTMENT DECISION

Answer 23

Use NPV based on cash flows over the whole life of projects.

Managerial performances are often evaluated using short-term financial measures.

Question 24

How to reduce dysfunctional consequences of short-term financial measures?

Answer 24

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.

Question 25

Economic Value Added

Answer 25

EVA: Conventional divisional profit +/- accounting adjustments - capital charge on divisional assets
(WACC x divisional controllable assets)

Question 26

WEIGHTED AVERAGE COST OF CAPITAL

Answer 26

• 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.

Question 27

Why adjust accounting figures using EVA?

Answer 27

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)

Question 28

Advantages of EVA

Answer 28

• Emphasises cost of capital charge
• Economic perspective
• Reduces the managerial myopia risk of ROI and RI.

Question 29

Limitations of EVA

Answer 29

• 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.

Question 30

NET BOOK VALUE

Answer 30

An asset’s historical cost minus accumulated depreciation.

Question 31

GROSS COST

Answer 31

Historical cost without the reduction for depreciation.

Question 32

HISTORICAL COSTS (acquisition cost)

Answer 32

Net Book Value

Gross Cost

Question 33

Current costs (based on economic value or replacement cost)

Answer 33

Replacement cost

Liquidation (realisable value)

Question 34

REPLACEMENT COST

Answer 34

The current cost to replace the assets at the current level of service and functionality.

Question 35

LIQUIDATION (REALISABLE) VALUE

Answer 35

The price that could be received from the asset’s sale.

Question 36

How to measure investment (assets)?

Answer 36

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)