Division Performance

Divisionalisation
In general, a large organisation can be structured in one of two
ways: functionally (all activities of a similar type within a company,
such as production, sales, research, are under the control of the
appropriate departmental head) or divisionally (split into divisions in
accordance with the products or services made or provided).
Divisional managers are therefore responsible for all operations
(production, sales and so on) relating to product, the functional
structure being applied to each division. It is possible, of course, that
only part of a company is divisionalised and activities such as
administration are structured centrally on a
functional basis with the responsibility of providing services to all
divisions
Decentralisation
In general, a divisional structure will lead to decentralisation of the
decision-making process and divisional managers may have the
freedom to set selling prices, choose suppliers, make product mix
output decisions and so on. Decentralisation is, however, a matter of
degree, depending on how much freedom divisional managers are
given

Advantages of divisionalisation
(a) Divisionalisation can improve the quality of decisions made
because divisional managers (those taking the decisions) know local
conditions and are able to make more informed judgements.
Moreover, with the personal incentive to improve the division's
performance, they ought to take
decisions in the division's best interests.
(b) Decisions should be taken more quickly because information
does not have to pass along the chain of command to and from top
management. Decisions can be made on the spot by those who
are familiar with the product lines and production processes and who
are able to react to changes
in local conditions quickly and efficiently.
(c) The authority to act to improve performance should motivate
divisional managers.
(d) Divisional organisation frees top management from detailed in
involvement in day-to-day operations and allows them to devote
more time to strategic planning.
(e) Divisions provide valuable training grounds for future
members of top management by giving them experience of
managerial skills in a less complex environment than that faced by top
management.
(f) In a large business organisation, the central head office will not
have the management resources or skills to direct operations
closely enough itself. Some authority must be delegated to local
operational managers

Disadvantages of divisionalisation
(a) A danger with divisional accounting is that the business
organisation will divide into a number of self-interested segments,
each acting at times against the wishes and interests of other
segments. Decisions might be taken by a divisional manager in the
best interests of his own part of the business, but against the best
interest of other divisions and possibly against the interests of the
organisation as a whole. A task of head office is therefore to try to
prevent dysfunctional decision making by individual divisional
managers. To do this, head office must reserve some power and
authority for itself so that divisional managers cannot be allowed to
make entirely independent decisions. A balance ought to be kept
between decentralisation of authority to provide incentives and
motivation, and retaining centralised authority to ensure that the
organisation's divisions are all working towards the same target, the
benefit of the organisation as a whole (in other words, retaining goal
congruence among the organisation's separate divisions).
(b) It is claimed that the costs of activities that are common to all
divisions such as running the
accounting department may be greater for a divisionalised structure
than for a centralisedstructure.
(c) Top management, by delegating decision making to divisional
managers, may lose control sincethey are not aware of what is going
on in the organisation as a whole. (With a good system of
performance evaluation and appropriate control information, however,
top management should be able to control operations just as
effectively
FAST FORWARD
Responsibility accounting
Responsibility accounting is the term used to describe
decentralisation of authority, with the performanceof the decentralised
units measured in terms of accounting results.
With a system of responsibility accounting there are three types of
responsibility centre: cost centre; profit centre; investment centre.
The creation of divisions allows for the operation of a system of
responsibility accounting. There are anumber of types of
responsibility accounting unit, or responsibility centre that can be
used within asystem of responsibility accounting.
In the weakest form of decentralisation a system of cost centres
might be used. As decentralisation becomes stronger the
responsibility accounting framework will be based around profit
centres. In itsstrongest form investment centres are used.

Return on investment (ROI)

The performance of an investment centre is usually monitored using
either or both of return on investment (ROI) and residual income
(RI).
ROI is generally regarded as the key performance measure. The
main reason for its widespread use is that it ties in directly with the
accounting process, and is identifiable from the income statement
and balance sheet. However it does have limitations, as we will see
later in this chapter.
Return on investment (ROI) shows how much profit has been made
in relation to the amount of capital invested and is calculated as
(profit/capital employed) x 100%.

For example, suppose that a company has two investment centres A

and B, which show results for the year as follows.
A B
N N
Profit 60,000 30,000
Capital employed 400,000 120,000
ROI 15% 25%
Investment centre A has made double the profits of investment centre
B, and in terms of profits alone has therefore been more 'successful'.
However, B has achieved its profits with a much lower capital
investment, and so has earned a much higher ROI. This suggests that
B has been a more successfulinvestment than A.

Measuring ROI
There is no generally agreed method of calculating ROI and it can
have behavioural implications and lead to dysfunctional decision
making when used as a guide to investment decisions. It focuses
attention on short-run performance whereas investment decisions
should be evaluated over their full life. ROI can be measured in
different ways

Profit after depreciation as a % of net assets employed

This is probably the most common method, but it does present a
problem. If an investment centre maintains the same annual profit,
and keeps the same assets without a policy of regular replacement of
non-current assets, its ROI will increase year by year as the assets get
older. This can give a false impression of improving performance
over time.For example, the results of investment centre X, with a
policy of straight-line depreciation of assets over a -year period, might
be as follows.

A new company has non-current assets of N460,000 which will be

depreciated to nil on a straight line basis over 10 years. Net current
assets will consistently be $75,000, and annual profit will consistently
be N30,000. ROI is measured as return on net assets.
Required
Calculate the company's ROI in years 2 and 6.

Profit after depreciation as a % of gross assets employed

Instead of measuring ROI as return on net assets, we could measure it
as return on gross assets ie before depreciation. This would remove
the problem of ROI increasing over time as non-current assets get
older. If a company acquired a non-current asset costing $40,000,
which it intends to depreciate by $10,000 pa for 4 years, and if the
asset earns a profit of $8,000 pa after depreciation, ROI might be
calculated on net book values or gross values, as follows.
Repeat Question: ROI calculation (1), measuring ROI as return on
gross assets.

However, using gross book values to measure ROI has its

disadvantages. Most important of these is that measuring ROI as
return on gross assets ignores the age factor, and does not distinguish
between old and new assets.
(a) Older non-current assets usually cost more to repair and
maintain, to keep them running. An investment centre with old assets
may therefore have its profitability reduced by repair costs, and
its ROI might fall over time as its assets get older and repair costs get
bigger.
(b) Inflation and technological change alter the cost of non-current
assets. If one investment centre has non-current assets bought ten
years ago with a gross cost of $1 million, and another investment
centre, in the same area of business operations, has non-current assets
bought very recently for $1 million, the quantity and technological
character of the non-current assets of the
two investment centres are likely to be very different.

Constituent elements of the investment base

Although we have looked at how the investment base should be
valued, we need to consider its appropriate constituent elements.
(a) If a manager's performance is being evaluated, only those
assets which can be traced directly to the division and are
controllable by the manager should be included. Head office assets
or investment centre assets controlled by head office should not be
included. So, for example, only those cash balances actually
maintained within an investment centre itself should be included.
(b) If it is the performance of the investment centre that is being
appraised, a proportion of the investment in head office assets
would need to be included because an investment centre could
not operate without the support of head office assets and
administrative backup.

Profits
We have looked at how to define the asset base used in the
calculations but what about profit? If the
performance of the investment centre manager is being assessed it
should seem reasonable to base profit on the revenues and costs
controllable by the manager and exclude service and head office
costs except those costs specifically attributable to the investment
centre. If it is the performance of the investment centre that is
being assessed, however, the inclusion of general service and head
office costs would seem reasonable.

ROI and new investments

If investment centre performance is judged by ROI, we should expect
that the managers of investment centres will probably decide to
undertake new capital investments only if these new investments are
likely to increase the ROI of their centre.
Suppose that an investment centre, A, currently makes a return of
40% on capital employed. The manager of centre A would probably
only want to undertake new investments that promise to yield a return
of 40% or more, otherwise the investment centre's overall ROI would
fall. For example, if investment centre A currently has assets of
N1,000,000 and expects to earn a profit of N400,000, how would the
centre's manager view a new capital investment which would cost
N250,000 and yield a profit of N75,000 pa?
 Without the new investment
With the new investment
Profit N400,000
N475,000
Capital employed N1,000,000
N1,250,000
ROI 40%
38%

The new investment would reduce the investment centre's ROI

from 40% to 38%, and so the investment centre manager would
probably decide not to undertake the new investment.
If the group of companies of which investment centre A is a part has a
target ROI of, say, 25%, the new investment would presumably be
seen as beneficial for the group as a whole. But even though it
promises to yield a return of 75,000/250,000 = 30%, which is above
the group's target ROI, it would still make investment centre A's
results look worse. The manager of investment centre A would, in
these circumstances, be motivated to do not what is best for the
organisation as a whole, but what is best for his division.
ROI should not be used to guide investment decisions but there is a
difficult motivational problem. If management performance is
measured in terms of ROI, any decisions which benefit the company
in the long term but which reduce the ROI in the immediate short
term would reflect badly on the manager's reported performance. In
other words, good investment decisions would make a manager's
performance seem worse than if the wrong investment decision were
taken instead

Residual income (RI)

RI can sometimes give results that avoid the behavioural problem of
dysfunctionality. Its weakness is that it does not facilitate
comparisons between investment centres nor does it relate the size of
a centre's income to the size of the investment.
An alternative way of measuring the performance of an investment
centre, instead of using ROI, is residual income (RI). Residual
income is a measure of the centre's profits after deducting a
notional or imputed interest cost.
(a) The centre's profit is after deducting depreciation on capital
equipment.
(b) The imputed cost of capital might be the organisation's cost of
borrowing or its weighted average cost of capital.

Residual income is a measure of the centre's profits after deducting a

notional or imputed interest cost.

A division with capital employed of N400,000 currently earns an ROI

of 22%. It can make an additional investment of N50,000 for a 5 year
life with nil residual value. The average net profit from this
investment would be N12,000 after depreciation. The division's cost
of capital is 14%.
What are the residual incomes before and after the investment?