Nội dung

13 Performance Evaluation of Business Units This chapter describes the methods by which the performance of divisions and their managers is evaluated. It builds on the foundation established in Chapter 2, which explained how divisionalized business structures have evolved to implement business strategy. We also consider controllability and the transfer pricing problem and introduce the theory of transaction cost economics. This chapter suggests that some techniques may provide an appearance rather than the reality of ‘rational’ decision-making. The decentralized organization and divisional performance measurement The evaluation of new capital expenditure proposals is a key element in allocating resources by the whole organization (see Chapter 12). However, a further aspect of strategy implementation is improving and maintaining divisional performance. Businesses may be organized in a centralized or decentralized manner. The centralized business is one in which most decisions are made at a head office level, even though the business may be spread over a number of market segments and geographically diverse locations. Decentralization implies the devolution of authority to make decisions. Divisionalization adds to decentralization the concept of delegated profit responsibility (Solomons, 1965). We introduced the notion of divisional structures and responsibility centres in Chapter 2. Divisionalization makes it easier for a company to diversify, while retaining overall strategic direction and control. Performance improvement is encouraged by assigning individual responsibility for divisional performance, typically linked to executive remuneration (bonuses, profit-sharing, share options etc.). Shareholder value is the criterion for overall business success, but divisional performance is the criterion for divisional success. However, divisional performance measurement has also moved beyond financial measures to incorporate the drivers of financial results, i.e. non-financial performance measures (see Chapter 4). Solomons (1965) highlighted three purposes for financial reporting at a divisional level: 196 ACCOUNTING FOR MANAGERS 1 To guide divisional managers in making decisions. 2 To guide top management in making decisions. 3 To enable top management to appraise the performance of divisional management. The decentralization of businesses has removed the centrality of the head office with its functional structure (marketing, operations, distribution, finance etc.). Instead, many support functions are now devolved to business units, which may be called subsidiaries (if they are legally distinct entities), divisions, departments etc. For simplicity, we will use the term divisionalization although the same principle applies to any business unit. This divisionalization allows managers to have autonomy over certain aspects of the business, but those managers are then accountable for the performance of their business units. Divisionalized business units may be: ž ž ž Cost centres – where managers are responsible for controlling costs within budget limits. Managers are evaluated on their performance compared to budget by keeping costs within budget constraints. Profit centres – where managers are responsible for sales performance, achieving gross margins and controlling expenses, i.e. for the ‘bottom-line’ profit performance of the business unit. Managers are evaluated on their performance compared to budget in achieving or exceeding their profit target. Investment centres – where managers have profit responsibility but also influence the amount of capital invested in their business units. Managers are evaluated based on a measure of the return on investment made by the investment centre. Budgets and performance against budget are the subjects of Chapters 14 and 15. Evaluating divisional performance in comparison to a strategic investment is the subject of this chapter. Solomons (1965) identified the difficulties involved in measuring managerial performance. Absolute profit is not a good measure because it does not consider the investment in the business and how long-term profits can be affected by short-term decisions such as reducing research, maintenance and advertising expenditure. These decisions will improve reported profits in the current year, but will usually have a detrimental long-term impact. The performance of divisions and their managers can be evaluated using two methods: either return on investment or residual income. Return on investment The relative success of managers can be judged by the return on investment (or ROI, which was introduced in Chapter 7). This is the rate of return achieved on the capital employed and was a method developed by the DuPont Powder Company early in the twentieth century. Using ROI, managerial and divisional success is judged according to the rate of return on the investment. However, a problem PERFORMANCE EVALUATION OF BUSINESS UNITS 197 with this approach is whether a high rate of return on a small capital investment is better or worse than a lower return on a larger capital. For example: Capital invested Operating profit Return on investment Div A £1,000,000 £200,000 20% Div B £2,000,000 £300,000 15% Division B makes a higher profit in absolute terms but a lower return on the capital invested in the business. Solomons (1965) also argued that a decision cannot be made about relative performance unless we know the cost of capital. Residual income A different approach to evaluating performance is residual income, which takes into account the cost of capital. Residual income (or RI) is the profit remaining after deducting the notional cost of capital from the investment in the division. The RI approach was developed by the General Electric Company and more recently has been compared with Economic Value Added (EVA, see Chapter 2), as both methods deduct a notional cost of capital from the reported profit. Using the above example: Capital invested Operating profit less cost of capital at 17.5% Div A £1,000,000 £200,000 £175,000 Div B £2,000,000 £300,000 £350,000 Residual income £25,000 −£50,000 As the cost of capital is 17.5% in the above example, Division A makes a satisfactory return but Division B does not. Division B is eroding shareholder value while Division A is creating it. The aim of managers should be to maximize the residual income from the capital investments in their divisions. However, Solomons (1965) emphasizes that the RI approach assumes that managers have the power to influence the amount of capital investment. Solomons argued that an RI target is preferred to a maximization objective because it takes into account the differential investments in divisions, i.e. that a larger division will almost certainly produce – or should produce – a higher residual income. Johnson and Kaplan (1987) believe that the residual income approach: overcame one of the dysfunctional aspects of the ROI measure in which managers could increase their reported ROI by rejecting investments that yielded returns in excess of their firm’s (or division’s) cost of capital, but that were below their current average ROI. (p. 165) 198 ACCOUNTING FOR MANAGERS One of the main problems in evaluating divisional performance is the extent to which managers can exercise control over investments and costs charged to their responsibility centres. Controllability The principle of controllability, according to Merchant (1987, p. 316), is that ‘individuals should be held accountable only for results they can control’ (p. 336). One of the limitations of operating profit as a measure of divisional performance is the inclusion of costs over which the divisional manager has no control. The need for the company as a whole to make a profit demands that corporate costs be allocated to divisions so that these costs can be recovered in the prices charged. The problem arises when a division’s profit is not sufficient to cover the head office charge (we introduced this concept in relation to segmentation in Chapter 8). Solomons (1965) argued that so long as corporate expenses are independent of divisional activity, allocating corporate costs is irrelevant because a positive contribution by divisions will cover at least some of those costs. Solomons separated these components in the divisional profit report, a simplified version of which is shown below: Sales Less Variable cost of goods sold Other variable expenses Contribution margin Less Controllable divisional overhead Controllable profit Less Non-controllable overhead Operating profit £££ £££ £££ £££ £££ £££ £££ £££ £££ While the business as a whole may consider the operating profit to be the most important figure, performance evaluation of the manager can only be carried out based on the controllable profit. The controllable profit is the profit after deducting expenses that can be controlled by the divisional manager, but ignoring those expenses that are outside the divisional manager’s control. What is controllable or non-controllable will depend on the circumstances of each organization. Solomons argued that the most suitable figure for appraising divisional managers was the controllable residual income before taxes. Using this method, the controllable profit is reduced by the corporate cost of capital. For decisions in relation to a division’s performance, the relevant figure is the net residual income after taxes. One of the problems with both the ROI and RI measures of divisional performance is the calculation of the capital investment in the division: should it be total (i.e. capital employed) or net assets (allowing for gearing)? Should it include fixed or current assets, or both? Should assets be valued at cost or net book value? Should the book value be at the beginning or end of the period? Solomons (1965) argued that it was the amount of capital put into the business, rather than what could be PERFORMANCE EVALUATION OF BUSINESS UNITS 199 taken out, that was relevant. The investment value, according to Solomons, should be total assets less controllable liabilities, with fixed assets valued at cost using the value at the beginning of the period. ROI calculations therefore relate controllable operating profit as a percentage of controllable investment. An RI approach would measure net residual income plus actual interest expense (because the notional cost of capital has been deducted in calculating RI) against the total investment in the division. The following case study provides an example of divisional performance measurement using ROI and RI techniques. Case study: Majestic Services – divisional performance measurement Majestic Services has two divisions, both of which have bid for £1 million for projects that will generate significant cost savings. Majestic has a cost of capital of 15% and can only invest in one of the projects. The current performance of each division is as follows: Current investment Profit Division A £4 million £1 million Division B £20 million £2 million Each division has estimated the additional controllable profit that will be generated from the £1 million investment. A estimates £200,000 and B estimates £130,000. Each division also has an asset of which they would like to dispose. A’s asset currently makes a return on investment (ROI) of 19%, while B’s asset makes an ROI of 12%. The business wishes to use ROI and residual income techniques to determine in which of the £1 million projects Majestic should invest, and whether either of the division’s identified assets should be disposed of. Using ROI, the two divisions can be compared as in Table 13.1. While Division B is the larger division and generates a higher profit in absolute terms, Division A achieves a higher return on investment. Again using ROI, the impact of the additional investment can be seen in Table 13.2. Using ROI, Division A may not want its project to be approved as the ROI of 20% is less than the current ROI of 25%. The impact of the new investment would be to reduce the divisional ROI to 24% (£1.2 million/£5 million). However, Division B would want its project to be approved as the ROI of 13% is higher Table 13.1 ROI on original investment Current investment Current profit ROI A B £4 million £1 million 25% £20 million £2 million 10% 200 ACCOUNTING FOR MANAGERS than the current ROI of 10%. The effect would be to increase Division B’s ROI slightly to 10.14% (£2.13 million/£21 million). However, the divisional preference for B’s investment over A, because of the rewards attached to increasing ROI, are dysfunctional to Majestic. The corporate view of Majestic would be to invest £1 million in Division A’s project because the ROI to the business as a whole would be 20% rather than 13%. The disposal of the asset can be considered even without knowing its value. If Division A currently obtains a 25% ROI, disposing of an asset with a return of only 19% will increase its average ROI. Division B would wish to retain its asset because it generates an ROI of 12% and disposal would reduce its average ROI to below the current 10%. Given a choice of retaining only one, Majestic would prefer to retain Division A’s asset as it has a higher ROI. The difficulty with ROI as a measure of performance is that it ignores both the difference in size between the two divisions and Majestic’s cost of capital. These issues are addressed by the residual income method. Using residual income (RI), the divisional performance can be compared as in Table 13.3. In this case, we can see that Division A is contributing to shareholder value as it generates a positive RI, while Division B is eroding its shareholder value because the profit it generates is less than the cost of capital on the investment. Using RI, the impact of the additional investment is shown in Table 13.4. Under the residual income approach, Division A’s project would be accepted (positive RI) while Division B’s would be rejected (negative RI). Similarly for the asset disposal, Division A’s asset would be retained (ROI of 19% exceeds cost of capital of 15%), while Division B’s asset would be disposed of (ROI of 12% is less than cost of capital of 15%). The main problem facing Majestic is that the larger of the two divisions (both in terms of investment and profits) is generating a negative residual income and consequently eroding shareholder value. Table 13.2 ROI on additional investment Additional investment Additional contribution ROI on additional investment A B £1 million £200,000 20% £1 million £130,000 13% Table 13.3 RI on original investment A B Current investment £4 million £20 million Current profit Cost of capital @ 15% £1,000,000 £600,000 £2,000,000 £3,000,000 £400,000 −£1,000,000 Residual income (profit – cost of capital) PERFORMANCE EVALUATION OF BUSINESS UNITS 201 Table 13.4 RI on additional investment Additional investment Additional contribution Less cost of capital @ 15% Residual income A B £1 million £1 million £200,000 £150,000 £130,000 £150,000 £50,000 −£20,000 A further problem associated with measuring divisional performance is that of transfer pricing, which was introduced in Chapter 8. Transfer pricing When decentralized business units conduct business with each other, an important question is what price to charge for in-company transactions, as this affects the profitability of each business unit. However, transfer prices that are suitable for evaluating divisional performance may lead to divisions acting contrary to the corporate interest (Solomons, 1965). For example, consider a company with two divisions. Division A can produce 10,000 units for a total cost of £100,000, but additional production costs are £5 per unit. Division A sells its output to Division B at £13 per unit in order to show a satisfactory profit. Division B carries out further processing on the product. It can convert 10,000 units for a total cost of £300,000, but additional production costs are £15 per unit. The prices B can charge to customers will depend on the quantity it wants to sell. Market estimates of selling prices at different volumes (net of variable selling costs) are: Volume 10,000 units 12,000 units 15,000 units Price £50 per unit £46 per unit £39 per unit The financial results for each division at each level of activity are shown in Table 13.5. Division A sees an increase in profit as volume increases and will want to increase production volume to 15,000 units. However, Division B sees a steady erosion of divisional profitability as volume increases and will seek to keep production limited to 10,000 units, at which point its maximum profit is £70,000. The company’s overall profitability increases between 10,000 and 12,000 units, but then falls when volume increases to 15,000 units. From a whole-company perspective, therefore, volume should be maintained at 12,000 units to maximize profits at £112,000. However, neither division will be satisfied with this result, 202 ACCOUNTING FOR MANAGERS Table 13.5 Divisional financial results Activity Division A 10,000 units 2,000 units @ £5 5,000 units @ £5 Total cost Transfer price @ £13 10,000 12,000 15,000 100,000 100,000 10,000 100,000 25,000 100,000 130,000 110,000 156,000 125,000 195,000 30,000 46,000 70,000 130,000 156,000 195,000 300,000 300,000 30,000 300,000 Division profit Division B Transfer from Division A Conversion cost 10,000 units 2,000 units @ £15 5,000 units @ £15 75,000 Total cost Selling price @ 430,000 50 486,000 46 570,000 39 Sales revenue 500,000 552,000 585,000 Division profit 70,000 66,000 15,000 500,000 −100,000 −300,000 100,000 552,000 −110,000 −330,000 112,000 585,000 −125,000 −375,000 85,000 Company Sales revenue Division A cost Division B cost Company profit Table 13.6 Division A costs Division A total costs Average per unit 10,000 12,000 15,000 100,000 10.00 110,000 9.17 125,000 8.33 as both will see it as disadvantaging them in terms of divisional profits, against which divisional managers are evaluated. For Division A, variable costs over 10,000 units are £5, but its transfer price is £13, so additional units contribute £8 each to divisional profitability. A’s average costs reduce as volume increases, as Table 13.6 shows. However for Division B, its variable costs over 10,000 units are £28 (transfer price of £13 plus conversion costs of £15). The reduction in average costs of £2.50 per unit is more than offset by the fall in selling price (net of variable selling costs), as Table 13.7 shows. PERFORMANCE EVALUATION OF BUSINESS UNITS 203 Table 13.7 Division B costs Division B total costs Average per unit Reduction in average cost per unit Reduction in selling price 10,000 12,000 15,000 430,000 43.00 486,000 40.50 2.50 4.00 570,000 38.00 2.50 7.00 There are several methods by which transfer prices between divisions can be established: ž ž ž ž ž Market price: Where products/services can be sold on the outside market, the market price is used. This is the easiest way to ensure that divisional decisions are compatible with corporate profit maximization. However, if there is no external market, particularly for an intermediate product – i.e. one that requires additional processing before it can be sold – this method cannot be used. Marginal cost: The transfer price is the additional (variable) cost incurred. In the above example, the transfer price would be £5, but Division A would have little motivation to produce additional volume if only incremental costs were covered. Full cost: This method would recover both fixed and variable costs. This has the same overhead allocation problem as identified in Chapter 11 and would have the same motivational problems as for the marginal cost transfer price. Cost-plus: This method provides a profit to each division, but has the problem identified in this example of leading to different management decisions in each division and at corporate level. Negotiated prices: This may take into account market conditions, marginal costs and the need to motivate managers in each division. It tends to be the most practical solution to align the interests of divisions with the whole organization and to share the profits equitably between each division. In using this method, care must be taken to consider differential capital investments between divisions, so that both are treated equitably in terms of ROI or RI criteria. In practice, many organizations adopt negotiated prices in order to avoid demotivating effects on different business units. In some Japanese companies it is common to leave the profit with the manufacturing division, placing the onus on the marketing division to achieve better market prices. Transaction cost economics A useful theoretical framework for understanding divisionalization and the transfer pricing problem is the transactions cost approach of Oliver Williamson (1975), which is concerned with the study of the economics of internal organization. Transaction cost economics seeks to explain why separate activities that require 204 ACCOUNTING FOR MANAGERS co-ordination occur within the organization’s hierarchy (i.e. within the corporate structure), while others take place through exchanges outside the organization in the wider market (i.e. between arm’s-length buyers and sellers). The work of business historians such as Chandler (1962) reflects a transaction cost approach in explanations of the growth of huge corporations such as General Motors, in which hierarchies were developed as alternatives to market transactions. It is important to note that transactions take place within organizations, not just between them. For managers using accounting information, attention is focused on the transaction costs associated with different resource-allocation decisions and whether markets or hierarchies are more cost effective. Transactions are more than exchanges of goods, services and money. They incur costs over and above the price for the commodity bought or sold, such as costs associated with negotiation, monitoring, administration, insurance etc. They also involve time commitments and obligations, and are associated with legal, moral and power conditions. Understanding these costs may reveal that it is more economic to carry out an activity in-house than to accept a market price that appears less costly but may incur ‘transaction’ costs that are hidden in overhead costs. Under transaction cost economics, attention focuses on the transaction costs involved in allocating resources within the organization, and determining when the costs associated with one mode of organizing transactions (e.g. markets) would be reduced by shifting those transactions to an alternative arrangement (e.g. the internal hierarchy of an organization). The high costs of market-related transactions can be avoided by specifying the rules for co-operative behaviour within the organization. The markets and hierarchies perspective considers the vertical integration of production and the decision about whether organizations should make or buy. Both bounded rationality and opportunistic behaviour are assumed in this perspective (see Chapter 6 for a discussion of this in relation to agency theory) and transaction costs are affected by asset specificity, when an investment is made for a specific rather than a general purpose. Transaction costs are also affected by uncertainty and the frequency with which transactions take place. Seal (1995) provided the example of a make versus buy decision for a component. In management accounting, a unit cost comparison would take place. (Relevant costs for make versus buy decisions were described in Chapter 9.) A transaction cost approach would consider whether the production of the component required investment in specialized equipment or training, a problem of asset specificity. This approach raises the problem that an external contract may be difficult to draw up and enforce because the small number of organizations bargaining may be hindered by opportunistic behaviour. It may therefore be cheaper to produce in-house due to contractual problems. Williamson (1975) argued that the desire to minimize transaction costs resulting from bounded rationality leads to transactions being kept within the organization, favouring the organizational hierarchy over markets. Markets are favoured where there are a large number of trading partners, which minimizes the risk of opportunistic behaviour.