© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 13

Performance Evaluation of Business Units CHAPTER 13 Performance Evaluation of Business Units © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 13 © 2009 John Wiley & Sons, Ltd, Accounting for Managers, 3rd ed., 9780470777640 Ch 1

Learning Objectives How has the change to multidivisional organizations impacted the way performance is evaluated within organizations? How can return on investment, residual income, and economic value added be used to assess the performance of company divisions? Should corporate-level costs be included in the evaluation of a business unit’s performance? Why is it important to use more than just financial measures of performance? How can transfer pricing be used to help motivate managers of divisionalized organizations to work cost-effectively and competitively? © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 13

Structure of Business Organizations Three types of Organizations 1. Private sector Businesses whose prime goal is profit. 2. Public sector Government funded and provides services for the public 3. Not-for-profit sector Provides a range of charitable or social services © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 13

Structure of Business Organizations Functional Organization Chart Divisional Organization Chart © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 13

Responsibility Centres Cost centre No income generation responsibility Managed by ability to operate within cost budget Profit centre Responsible for ‘bottom line’ profits Evaluated on their performance compared to budget in achieving or exceeding their profit target Investment centre Have profit responsibility Evaluated based on a measure of the return on investment made by the investment centre © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 13

The Decentralized Organization and Divisional Performance Measurement Decentralization Devolution of authority to make decisions Divisionalization Include both financial and non-financial performance measures Divisional performance can be assessed through budgets and performance against budgets Can also be assessed in terms of their ability to manage and earn income relative to their strategic investments © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 13

Methods of Divisional Performance Measurement Return on investment (ROI) Residual income, Economic value added © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 13

Return on Investment (ROI) Rate of return achieved on the capital employed ROI Operating profit = Total assets © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 13

Example 2 Divisions Division A Division B Investment $4,000,000 $20,000,000 Profit $1,000,000 $2,000,000 Absolute profit is higher $1,000,000 is available for investment 2 competing projects Cost of capital 15% Anticipated profit Division A Division B Profit $200,000 $130,000 © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 13

Example - ROI Original Investment $4,000,000 $20,000,000 Division A Division B Original Investment $4,000,000 $20,000,000 Profit $1,000,000 $2,000,000 ROI 25% 10% Additional investment $1,000,000 $ 1,000,000 Profit $200,000 $130,000 ROI on additional investment 20% 13% Total investment $5,000,000 $21,000,000 Profit $1.200,000 $2,130,000 ROI 24% 10.1% © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 13

© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 13 Example - ROI Division A may not want its project to be approved as its overall ROI will fall from 25% to 24% Division B may want its project to be approved as its overall ROI will increase from 10% to 10.1% Corporate view is to prefer Division A investment as it earns a higher ROI © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 13

Residual Income (RI) Profit remaining after deducting a portion of the capital invested that represents the cost of capital from the investment in the division Residual income = Operating profit before tax - Capital charge © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 13

Example – Residual Income Division A Division B Original Investment $4,000,000 $20,000,000 Profit $1,000,000 $2,000,000 Cost of capital 15% $600,000 $3,000,000 Residual income $400,000 -$1,000,000 Additional investment $1,000,000 $ 1,000,000 Profit $200,000 $130,000 Cost of capital 15% $150,000 $150,000 Residual income $50,000 -$20,000 © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 13

Example – Residual Income Under the residual income method, Division A’s project would be approved as it contributes to shareholder value, whereas Division B’s project erodes shareholder value Compare the cost of capital of 15% to Division B’s ROI (13% on new investment) © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 13

Comparison of Techniques Residual income is considered a stronger measure than ROI because managers do not feel constrained to meet a percentage target Managers will make investments that have a return in excess of a firm’s cost of capital, whereas if they used only ROI as a basis for evaluation, they might reject an investment if it lowers the division’s overall ROI © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 13

Economic Value Added It deducts a percentage of the invested capital from income to determine the true earnings of a division It is calculated using after-tax earnings It deducts the current liabilities from total assets when determining the total invested capital for the division © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 13 © 2009 John Wiley & Sons, Ltd, Accounting for Managers, 3rd ed., 9780470777640 Ch 1

Economic Value Added Where d is the cost of debt for the firm e is the cost of equity for the firm MVd is the market value of the firm’s debt MVe is the market value of the firm’s equity © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 13 © 2009 John Wiley & Sons, Ltd, Accounting for Managers, 3rd ed., 9780470777640 Ch 1

Example Long-term debt market value = $12 million Equity market value = $15 million Cost of debit = 10% Cost of equity = 15%. Total assets = $10,500,000 After-tax profit = $1,525,000 Current liabilities end of period = $500,000 © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 13 © 2009 John Wiley & Sons, Ltd, Accounting for Managers, 3rd ed., 9780470777640 Ch 1

Example © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 13 © 2009 John Wiley & Sons, Ltd, Accounting for Managers, 3rd ed., 9780470777640 Ch 1

Controllability 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 Allocating corporate charges to a division may be necessary for financial reporting but is not always desirable for performance evaluation purposes Performance evaluation of managers can be carried out based only on the controllable profit. The controllable profit is the profit after deducting expenses that can be controlled by the divisional manager, but it ignores those expenses that are outside the divisional manager’s control © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 13

Controllability Manager accountable for Divisional performance © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 13

Non-Financial Performance Evaluation Balanced Scorecard © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 13 © 2009 John Wiley & Sons, Ltd, Accounting for Managers, 3rd ed., 9780470777640 Ch 1

Transfer Pricing Intention of transfer pricing is to create an environment where managers are encouraged act competitively by controlling costs and managing capacity efficiently By using transfer prices between divisions, managers of the supplying division are encouraged to make a profit and, thus, to work efficiently and cost-effectively © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 13

Transfer Pricing Transfer prices between divisions can be established using several methods Market transfer price Marginal cost-based transfer price . Full-cost transfer price. Cost-plus transfer price Negotiated transfer price © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 13

Transfer Pricing Example Division A produces 10,000 units at a cost of $100,000, with additional production costs at $5 per unit Division A sells its output to Division B at $13. Division B carries out further processing which costs $300,000 with additional costs of $13 per unit for units over 10,000. Selling Price depends on quantity: 10,000 units $50/unit 12,000 units $46/unit 15,000 units $39/unit © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 13

Transfer Pricing Example Divisional Financial Results © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 13

Transfer Pricing Example Number of Units © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 13

Conclusions Responsibility centres Cost, profit & investment centres Divisional performance measurement Return on Investment, Residual Income, Economic Value Added Controllability Non-Financial Performance Evaluation Transfer pricing © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 13