Divisional Performance Measurement Essay Example
Divisional Performance Measurement Essay Example

Divisional Performance Measurement Essay Example

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  • Pages: 7 (1777 words)
  • Published: September 3, 2017
  • Type: Essay
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The objective of divisional performance measurement is to develop performance measurement systems for divisions that are significant investment centers in large organizations. Such systems should: (1) provide information for economic decisions, (2) facilitate the control of division operations, (3) motivate managers to achieve high levels of divisional performance so as to further the objectives of the entire organization, and (4) serve as a basis for evaluating the performance of divisional managers.

The nature of diversification As a special case of decentralization, diversification represents the incept of delegated profit and, to some extent, investment responsibility. Divisions usually perform many of the basic business functions themselves - 2. Planning, production, accounting, marketing, and some financing activities. Definitions: A segment off business is recognized as a division when it 3. Exercises res

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ponsibility for both producing (or purchasing) and marketing products or services. Normally a division has some control over both sources of supply and the customers served.

A segment is recognized as an administered center when it is a captive customer of other units within the same economic entity. A division has ore of an independent business unit than an administered center. Reasons for diversification. Work sharing is one very simple reason for delegating decision-making authority. As firms become larger, and serve more diverse markets, the decision-making process can become bogged down and out-of-touch if it is center in a few individuals. Committees are utilized in order to coordinate information and to improve decisions in place of individual executives. . Devotionals operations make use of specialized skills such as knowledge about a particular product, a particular type of customer, a market or a geographic area. The ide

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is to better utilize specialized knowledge by letting the managers with the specialized knowledge make more decisions. Greater manager motivation is believed to result when the creative talents of responsible individuals can develop in a climate of individual responsibility, authority and dignity made possible by the decentralization of decision-making authority. . Divisional operations provide a good training ground for top management positions because a division manager has the opportunity to make a variety of decisions which would not be possible in either functional areas or in positions of limited responsibility. Conditions necessary for diversification to succeed 1 . Each division should be sufficiently independent of other divisions with respect to both production activities and marketing activities to make its separate profit responsibility a meaningful reality.

In order for the company to prosper as an economic entity, a certain amount of cooperation and interdependence among the divisions is necessary to achieve corporate goals. The objective is to fully exploit opportunities for operating, investment, and product-line synergies. Relations between divisions must be regulated so that no division, by seeking its win profit, can reduce that of the corporation. The corporate administration must maintain some self-restraint in issuing directives to division managers to ensure division managers are making decisions and not Just administering decisions made at a higher level.

Problems associated with diversification. Devotionals administrative systems are more expensive to operate, so that the benefits must outweigh the added costs. It requires more administrative talent to operate a firm. Sufficient talent may not be available at any one point in time. The top management skills needed to run a devotionals firm are different than he skills needed to

run a centralized firm, so top management personalities must be consistent with the organizational structure adopted.

Divisional Performance Measures Divisional Income: Divisional income is a measure of divisional performance that is analogous to corporate net income for evaluating overall company performance. Similar to related- party transactions in the context of financial accounting, the calculation of divisional income must consider transactions that occur between divisions, and between the division and corporate headquarters. One type of intra-company transaction is the ranges of goods between divisions.

These transfers, which represent revenue to the selling division and a cost of inventory to the buying division. Another type of transaction is the receipt of services from corporate headquarters or from other responsibility centers within the company. Examples of such services are human resources, legal, risk management, and computer support. In many companies, these services are "charged out" to the divisions that utilize them. Because divisional income fails to account for the size of the division, it is ill-suited for comparing performance across divisions of different sizes.

Divisional income is most meaningful as a performance measure when compared to the same division in prior periods, or to budgeted income for the division. Return on Investment: Return on investment (ROI) is calculated as: Return on Investment I = I Divisional Income I I I Divisional Investment I The same issues arise in determining the numerator in ROI as arise in the previous subsection with respect to deriving divisional income. As regards the denominator, senior management must decide whether and how to allocate shared assets among divisions, such as service departments at the corporate level, or shared manufacturing facilities.

Also, management must decide

how to value the capital assets that comprise the division's investment. These assets can be valued at their gross book value (the acquisition cost), their net book value (usually the acquisition cost minus depreciation expense), or less often, some other valuation technique such as replacement cost, net realizable value or fair market value. The calculation of the numerator should be consistent with the choice of valuation technique in the denominator.

For example, if divisional investment is calculated using gross book value, then divisional income in the numerator should not be reduced by appreciation expense. ROI can be broken down into the following two components: ROI I = I Divisional Income I ? I Divisional Income I X I Divisional Revenue I I I Divisional Investment I I Divisional Revenuer I Divisional Investment I The first term on the right-hand side is called the return on sales (ROSS). It is also called the operating profit percentage.

ROSS is often an important measure of the efficiency of the division, and the divisional manager's ability to contain operating expenses. The second term on the right-hand side is called the asset turnover ratio or the investment turnover ratio. This ratio measures how effectively management uses the division's assets to generate revenues.. Breaking ROI into these two components often provides more useful information than looking at ROI alone, and it is an example of the type of financial ratio analysis that stock analysts conduct in evaluating company-wide performance.

In this context, two common specifications for the denominator in the ROI calculation are assets and equity. The resulting ratios are called return on assets (ROAR) and return on equity (ROE). At

the divisional level, ROI controls for the size of the division, and hence, it is well-suited for comparing visions of different sizes. On the other hand, similar to the Internal Rate of Return for evaluating capital projects, ROI can discourage managers from making some investments that shareholders would favor.

For example, if a divisional manager is evaluated on ROI, and if the division is currently earning an ROI in excess of the company's cost of capital, then the manager would prefer to reject an additional investment opportunity that would earn a return above the cost of capital but below the division's current ROI. The new investment opportunity would lower the division's ROI, which is not in the manager's best interests. However, because the investment opportunity provides a return above the cost of capital, shareholders would favor it.

Residual Income: One way in which financial accounting practice fails to follow corporate finance theory is that the cost of debt is treated as an expense in arriving at net income, but the cost of equity is not. Specifically, interest expense appears as a deduction to income on the income statement, but dividends are shown on the statement of changes in shareholders' equity. Hence, net income is affected by the company's financing strategy as well as by its operating profitability, which can obscure the economic performance of the firm.

A simple solution to this problem is to add back interest expense (net of the tax effect) to net income, to arrive at operating income after taxes. The performance measure called residual income makes this adjustment, and then goes one step further, by deducting a charge for capital based

on the organization's total asset base: Residual Income = Operating Income (Investment Base x Required Rate of Return) The company's cost of capital is often appropriate for the required rate of return.

Residual income is probably the closest proxy that counting provides for the concept of economic profits; hence, residual income probably comes close to measuring what shareholders really care about (to the extent that shareholders only care about maximizing wealth). Residual income can be calculated both at the corporate level and at the divisional level. Many companies that use residual income at the divisional level do so because management believes that residual income aligns incentives of divisional managers with incentives of senior management and shareholders.

One type of residual income calculation is called Economic Value Added. EVA was developed by the consulting firm of Stern Stewart ; Co. , and is a registered trademark of that firm. The calculation of EVA includes a deduction for the cost of capital, and also adjusts accounting income to more accurately reflect the economic effect of transactions and the economic value of assets and liabilities.

In general, these adjustments move the income calculation further from the reliability-end of the relevance-versus-reliability continuum, and closer to the relevance-end of that continuum. Since the asses, EVA has helped revive the popularity of residual income. However, it should be emphasized that although Stern Stewart has obtained trademark protection on the term "EVA," the concept of residual income precedes EVA by almost half a century, and it is in the public domain.

Anyone can use residual income for any purpose whatsoever without violating trademark, copyright or patent law, and this includes making obvious

adjustments to net income to more accurately reflect the underlying economic reality of the firm. Limitations of Accounting Measures of Performance Due to timing differences between cash flows and income flows, performance is being measured on a basis that may be inconsistent with the investment criteria in SE by management and by investors in the firm. Accounting Measures of Performance.

  • Accounting measures are relatively insensitive to the time-value-of money except that portion reflected by the explicit interest cost.
  • Accounting measures are relatively insensitive to sudden shifts in risk level although various measures of risk tend to be correlated over time.
  • Changing price levels can "cover-up" poor sales and earnings growth and make comparisons more difficult.
  • Unrealized changes in resource prices are extremely important in some situations but are reported on a limited, ad hoc basis.
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