How to Measure Divisional Performance? [Top 2 Methods] | Cost Accounting

The following article will guide you about the two methods adopted for measuring divisional performance.

Method # 1. Return on Investment (ROI):

Many organizations use return on investment (ROI) to measure divisional performance. ROI expresses divisional profit (operating profit) as a percentage of assets employed in the division. Some companies use net profit after tax as the numerator in calculating the ROI.

Decid­ing on the denominator is a complex decision. Many companies allocate corporate equity to different divisions on some equitable basis (e.g., proportion of total assets employed in each division) and use the same as a denominator.

Some firms use capital employed, (i.e. fixed assets + working capital) as the denominator. However, considerable variations are found in practice on how working capital is treated. Many firms use gross working capital particularly if divisional managers have no influence on trade creditors or other current liabilities. Others prefer to use net working capital as it provides a good measure of corporate resources allo­cated to the business, and managers are expected to earn an adequate return on the same.

Many organizations use book value of fixed assets in calculating capital employed in the division. However, use of book value often misstates the division profitability. Use of book value reduces capital employed and increases ROI every successive year without any real improvement in economic performance. Therefore, use of book value may not motivate divisional manages to acquire new fixed assets.

Better alternatives are the use of replacement cost or the original cost of acquisition (gross book value). However, use of replacement cost or original cost presents some practical problems because it is difficult to ascertain replacement costs of different assets acquired at different points of time having different residual values. If original cost of an asset is used managers may be motivated to dispose of assets even if they have some usefulness.

Companies prefer to use net book-value methods in preference to others because non-accounting methods have an element of subjectivity, while financial accounting methods have an aura of reality for operating managers. The selection of a particular method ultimately depends on the assessment of corporate management of what practice would induce divisional man­agers to efficiently use resources and to acquire proper amount and kind of new assets.

The following are the advantages of ROI for measuring divisional performance:

(a) It is a comprehensive measure and captures all the factors which influence figures in financial statements.

(b) It is easy to calculate and understand.

(c) It makes comparison of performances of different divisions easy.

(d) Data on ROI of different companies are easily available and that helps in inter-firm comparison.

In spite of these advantages many companies do not use ROI for measuring divisional performance because it has the potential to create serious dysfunctional effect.

Use of ROI may motivate divisional managers to avoid acquisition of assets which would decrease the ROI of the division even though it would improve the performance of a company as a whole. E.g., if the current ROI of a division is 20% it would not acquire an asset which would earn a return of 18% although the weighted average cost of capital of the company is 15%.

Thus ROI creates a bias towards no or little additional investment. Man­agers may also take wrong asset disposal decisions. Similarly, a division which has a very low ROI may be tempted to improve ROI by acquiring assets which will improve its ROI although its earning will be lower than the cost of capital of the company.

In view of this serious limitation, many companies use ‘RI’ as a measure of divisional performance.

Method # 2. Residual Income (RI) or Economic Value Added (EVA):

Residual Income is pre-tax profit less an imputed interest charge for invested capital.

The imputed interest charge is often referred to as capital charge in management literature. This capital charge is found by multiplying the amount of assets employed by a rate. Selecting the rate of capital charge also poses some problems.

The simplest method is to use company’s cost of capital. However, a sophisticated method uses different rates for different classes of assets—may be one rate for general-purpose assets, while a special rate for special-purpose assets.

Some companies use a rate which is close to the company’s cost of borrowing rather than to its cost of capital.

While ROI is a ratio, RI is an absolute figure. RI deals with the problems of ROI adequately because any investment, which will earn higher than the capital charge will improve the RI. Therefore, use of RI motivates divisional managers to acquire only those assets, which will improve the performance of the company as a whole. Thus, the RI method sets the same profit objective for same assets in different divisions.

A sophisticated system also solves the problem of the same profit objective for different assets in the same division by using different rate of capital charges for different class of assets. RI is definitely a superior measure compared to ROI for measuring divisional performance.

Stern Steward & Co., a consultancy firm in USA, uses the term EVA for RI. The Stern Steward & Co. suggests many adjustments to correct the distortions in reported profit and capital due to accounting bias towards prudence. Many firms use EVA as the basis for cal­culating variable part of the executive compensation to induce managers to behave like owners, who in a business to create wealth for themselves.

Illustration:

Sliced Bread Plc. is a divisionalized company. Among its divisions are Grain and Bak­ery. Grain’s operations include granaries, milling, and dealings in the grain markets, while Bakery operates a number of bakeries.

The following data relate to the year ended 30 November 2004:

Divisional managements (DMs) are given authority to spend up to £20,000 on capital item as long as total spending remains within an amount provided for small projects in the annual budget. Larger projects, as well as sales of assets with book values in excess of £20,000 must be submitted to central management (CM). All day-to-day operations are delegated to DMs, whose performance is monitored with the aid of budgets and reports.

The basis for appraising DM performance is currently under review. At present divi­sions are treated as investment centres for DM performance appraisal, but there is a dis­agreement as to whether return on capital employed (ROCE) or RI is the better measure. An alternative suggestion has been made that DM performance should be appraised on the basis of controllable profit; this measure would exclude depreciation and gains or losses on sale of assets, treating investment in fixed assets as CM responsibility.

The cost of capital of Sliced Bread Pic., is 15% per annum.

Requirement:

Calculate for both divisions, the three measures (ROCE, RI, and controllable profit), that are being considered by Sliced Bread Plc., and state any assumptions or reservations about the data you have used in your calculations.

Solution:

The gain on the sale of plant of the Bakery division has been excluded from the above figures, since this is assumed to refer to a decision taken by the CM. The objective is to measure managerial performance and therefore allocated head-office costs are excluded in above calculations. However, depreciation has been deducted to calculate the divisional profits.

Some experts argue that for computing divisional profits only depreciation on controllable investment should be deducted and therefore ROCE and RI should exclude depreciation on non-controllable investments. Controllable profit is calculated excluding all depreciation charges.

ROCE and RI are calculated based on year-end book value of fixed assets, while aver­age value should be used for a better measure of ROCE and RI. Moreover, use of replace­ment cost is advocated because use of book value misstates ROCE and RI.

The overall company cost of capital has been used for calculating RI. However, it is more appropriate to use a rate which properly represents risks of divisional investments.