Performance management

Unit 8 – Part A
 Financial Management 300
Unit 8 – Learning Outcomes
Distinguish between divisionalised and non-divisionalised organisational
structures

Distinguish among the traditional types of segments

Distinguish between managerial and economic performance

Explain different measures available for measuring performance and discuss the
pros and cons of each

Explain the impact of inflation, depreciation and capital budgeting on

performance measures.

List and discuss the long-term consequences of using short-term performance

measures (ie: profit, ROI and RI).
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 Performance Management

Goal Congruence
Divisional Structure

Control Assess Performance

Divisional Manager’s Divisional

Performance Performance

ROI
1. Historical
accounting
RI 2. Short term

EVA
Balanced
Scorecard
 Financial Management 300
Outcome 1
Autonomous divisions
Danger
• Divisional managers might not pursue goals that are in the best interest
of the company as a whole

Objective
• To develop performance measures that will achieve goal congruence

Focus
• Financial measures of divisional performance
• Non-financial measures

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 Financial Management 300
Outcome 2
Types of segments: Responsibility centres

Cost centres
• Manager is responsible for costs and not profits.

Profit centres
• Manager is responsible for profit obtained from operating the
assets assigned to him/her by corporate head office.

Investment centres
• Managers make decisions on sources of supply, choice of
markets, and are responsible for making capital investment
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decisions
 Financial Management 300
Outcome 1
Organisational structures

NON-DIVISIONALISED DIVISIONALISED
(CENTRALISED/FUNCTIONAL) (DECENTRALISED)
Similar activities grouped together Split according to products made
Revenue / Cost centres Investment / Profit centres
Organisation as a whole = Organisation = divided into separate
Investment centre investment / profit centres
Decisions made by central Decentralisation of decision-making
management (autonomous divisions)
Managers do not have profit Managers have profit responsibility
responsibility and can make decisions relating to:
 Selling prices
 Product mix decisions
 Selecting suppliers
 Choose which market to sell in.
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 Financial Management 300
Outcome 1
ORGANISATIONAL STRUCTURES
Non-divisionalised structure (Functional structure):

In a non-divisionalised structure all activities or functions of a similar type are placed

under the control of a manager.

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Financial Management 300
Outcome 1

8
 Financial Management 300
Outcome 1
ORGANISATIONAL STRUCTURES
Divisionalised structure:
In a divisional structure an organisation is split up into divisions according to the
products (or geographical regions).

A functional structure is then applied to each division, meaning every division will
have its own production, finance, marketing, procurement etc. department.

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Financial Management 300
Outcome 1
CEO / Executive
Management
(Head Office)

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 Financial Management 300
Outcome 1
Divisionalisation - Advantages:
• Quality of decisions – a relatively flat structure ensures effective communication
and problem identification;
• Speed of decisions – a divisionalised structure eliminates long approval
procedures and ensures that decisions are taken at the appropriate levels where it
can be controlled;
• Top management can devote their time to strategic planning;
• A divisionalised structure serves as a good training ground for prospective
managers.
• Motivation and efficiency will increase as managers have control over their own
destiny;
• Freedom to managers – management have the opportunity to achieve their own
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set objectives.
 Financial Management 300
Outcome 1
Divisionalisation - Disadvantages:

• Inter-divisional competition and rivalry could be to the detriment of the

company as a whole;
• Costs of activities that are common to all divisions may be duplicated such
as finance and procurement;
• Top management loses some control by delegating decision-making to
lower levels.
• Increased risk of acting against the best interest of the organisation as a
whole (making decisions with best interest of the unit under their control, at the
exclusion of other considerations).
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 Financial Management 300
Outcome 3

EVALUATING MANAGERIAL PERFORMANCE

Total sales revenue xxx

Less variable costs (xxx)
Variable contribution xxx
Less controllable fixed costs (xxx)
Controllable contribution/profit xxx

“Controllable fixed costs” depend on the responsibility of the manager

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 Financial Management 300
Outcome 3
EVALUATING DIVISIONAL ECONOMIC PERFORMANCE

Total sales revenue xxx

Less variable costs (xxx)
Variable contribution xxx
Less controllable fixed costs (xxx)
Controllable contribution/profit xxx
Less non-controllable fixed costs (xxx)
Divisional contribution/profit xxx
Less allocated corporate expenses (xxx)
Divisional profit before taxes xxx

“Non-controllable fixed costs” recognises fixed costs directly attributed to

the division, but not controllable by divisional manager.
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 Financial Management 300
Outcome 4

RETURN ON INVESTMENT (ROI)

• Expresses divisional profit as a percentage of the assets employed

in the division.

• Assets employed = total divisional assets, assets controllable by

the divisional manager, or net assets.

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 Financial Management 300
Outcome 4
RETURN ON INVESTMENT (ROI)

Advantages:

• ROI is easy to calculate and interpret, given the simple formula for which the
inputs are readily available in the organisations’ financial information systems.

• Because ROI relates divisional profit generated to the size of the assets
employed, managers are encouraged to use assets productively.

• Because ROI is expressed in percentage terms, a unit’s ROI can easily be

compared to that of other entities and to indicators such as cost of capital, prime
interest rate, or bond yields.

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 Financial Management 300
Outcome 4
RETURN ON INVESTMENT (ROI)

Disadvantages

• Problems exist when it is used to evaluate the performance of divisional

managers → sub-optimal decisions (see example)

• Managers can also be motivated to make incorrect asset disposal

decisions.

• ROI is calculated using accounting information. Future cash flows, not

accounting figures, should be used in decision-making.

• ROI is a short-term measure based on historical results.

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 Financial Management 300
Outcome 4
RETURN ON INVESTMENT (ROI)
Example 1:
Division A Profit R1 million
Division B Profit R2 million

Division A = Assets employed R4 million

Division B = Assets employed R20 million

Divisional profit expressed as a % of assets employed in that division.

ROI A = 25% B = 10%

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 Financial Management 300
Outcome 4
RETURN ON INVESTMENT (ROI)
Example 2:
Evaluating divisional managers on the basis of ROI may not encourage goal
congruence for the company as a whole.

New Project Division X Division Y

Investment required R1 million R1 million
Expected contribution R200 000 R130 000
Expected project return 20% 13%

Current performance
Divisional ROI 25% 9%

19 Cost of capital for the company 15%

 Financial Management 300
Outcome 4
RESIDUAL INCOME (RI)

• For evaluating the performance of divisional managers = Controllable

contribution
(LESS) Cost of capital charge on investments controllable by the divisional
manager

• For evaluating the economic performance of the division = Divisional

contribution
(LESS) Cost of capital charge on the total investment in assets employed
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by the division
 Financial Management 300
Outcome 4
RESIDUAL INCOME (RI) (continued):
Advantages:
• Sub-optimal decisions are discouraged.
• Also encourages managers to make correct asset disposal decisions.
• It is more flexible as different cost of capital percentage rates can be applied to
investments that have different levels of risk.
Disadvantages:
• It is an absolute measure → it is difficult to compare the performance of a
division with that of other divisions / companies of a different size .
• RI is calculated using accounting information.
• RI is a short-term measure based on historical results.
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 Financial Management 300
Outcome 4
RESIDUAL INCOME (RI)

Example 2 (continued):

Residual income equals controllable contribution of a project less a cost of capital

charge on the investment controllable by the divisional Manager. Projects with a
negative residual income should be rejected.
Division X Division Y
Investment R1 million R1 million

Controllable contr. R200 000 R130 000

Less: 15% Cost of
Capital charge (R150 000) (R150 000)
Residual income R50 000 (R20 000)

Accept Reject
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 Financial Management 300
Outcome 4
ECONOMIC VALUE ADDED (EVA)
• Calculations for EVA will only be performed @ Honours level, not 3rd year.
• EVA extends traditional RI measure by incorporating adjustments
• EVA = divisional profit +/-accounting adjustments – COC charge on divisional
assets
• COC is included as companies only create shareholder value when generating a
return in excess of the return required by the providers of capital (ie: both debt and
equity). Certain traditional profit measures includes the cost of debt finance but
ignores the cost of equity finance.
• Adjustments are made to divisional profit in order to replace historic accounting data
that does not reflect shareholder wealth. It attempts to measure approximate
economic value.
• ie: Capitalisation of discretionary expenditures (research & development, marketing,
advertising) by spreading these costs over the periods in which the benefits are
received. Therefore, managers will not bear the full cost in the period in which they
are incurred, but they are rather spread across the periods when the benefits are
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expected to be received.
 Financial Management 300
Outcome 4
Assets to be included in Investment
Base
• Investment base for ROI + RI + EVA

• Performance of divisional manager: Only assets/liabilities that can

be directly traced to the division and that are controllable by the
divisional manager (.ie: assets/liabilities managed by H/O should not
be included)

• Performance of division: Include H/O allocated assets/liabilities

(i.e: buildings, cash & debtors managed at corporate level), as these
assets/liabilities would be included in the investment base if the
division were a separate independent company.
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 Financial Management 300
Outcome 5: Impact of depreciation on
performance evaluation techniques.

Example 3:
• Consider an investment in assets of R1 million with a life of 5 years with
annual cash flows of R350 000 and a cost of capital 10%. Since the NPV is
positive it was decided to accept the project. (NPV = R326 850)
• Calculate the ROI and Residual Income per year assuming the cost of capital
charge is based on:
1. Written down values
2. Initial values

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 Financial Management 300
Outcome 5
COST OF CAPITAL CHARGE BASED ON WRITTEN DOWN VALUE
1 2 3 4 5

Net cash flow 350 000 350 000 350 000 350 000 350 000
Depreciation 200 000 200 000 200 000 200 000 200 000
Profit 150 000 150 000 150 000 150 000 150 000

Written down 1 000k 800 000 600 000 400 000 200 000
value
Cost of 100 000 80 000 60 000 40 000 20 000
Capital charge
RI 50 000 70 000 90 000 110 000 130 000

ROI 15% 18,75% 25% 37,5% 75%

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 Financial Management 300
Outcome 5

COST OF CAPITAL CHARGE BASED ON INITIAL

INVESTMENT/ STRAIGHT LINE DEPRECIATION
1 2 3 4 5

Net cash 350 000 350 000 350 000 350 000 350 000
flow
Depreciation 200 000 200 000 200 000 200 000 200 000
Profit 150 000 150 000 150 000 150 000 150 000

Initial Cost 1 000k 1 000k 1 000k 1 000k 1 000k

CoC 100 000 100 000 100 000 100 000 100 000
RI 50 000 50 000 50 000 50 000 50 000

ROI 15% 15% 15% 15% 15%

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 Financial Management 300
Outcome 5

THE IMPACT OF DEPRECIATION

Conclusion:
Old or depreciated assets provides a distorted figure in calculating ROI
and RI, and can pursuade management to postpone new investments,
ultimately leading to the detriment of the organisation in the long run.

Theoretically the correct solution should be to value assets at the PV of

future cash flows. This is however difficult in practice. As an alternative,
assets could be valued at the replacement cost.
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 Financial Management 300
Outcome 5
PERFORMANCE MEASUREMENT & CAPITAL
BUDGETING DECISIONS
Example 4
Projects X Y Z
Cost 861 861 861
Net cash flow: year 1 250 390 50
Net cash flow: year 2 370 250 50
Net cash flow: year 3 540 330 1 100
NPV @ 10% 77 (52) 52
Ranking based on NPV 1 3 2

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 Financial Management 300
Outcome 5

Calculation of Return on Investment for Project X - year 1:

Net cash flow 250
Less: Depreciation (287) Book value (861) / 3 = 287
Net profit (37)
ROI (37 / 861) (4,3%)

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 Financial Management 300
Outcome 5
Projects X Y Z
Profits Year 1 (37) 103 (237)
Year 2 83 (37) (237)
Year 3 253 43 813
Total profits 299 109 339

ROI year 1 (4,3%) 11,9% (27,5%)

year 2 14,5% (6,4%) (41,3%)
year 3 88,1% 15% 283,2%
Average ROI 32,8% 6,8% 71,5%
Ranking based on ROI 2 3 1
Ranking based on NPV 1 3 2
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 Financial Management 300
Outcome 5
PERFORMANCE MEASUREMENT & CAPITAL
BUDGETING DECISIONS
• Divisions are often seen as collection of different investments whose income streams
result from different risks. Different costs of capital should therefore be used for different
divisions, based on the relative risk of each division.
• It is impossible to capture in one financial measure all variables that measure divisional
success.
• Managerial performance should rather focus on future results expected from present
actions.
• Performance measures should support corporate objectives and company’s competitive
strategies.

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The Balanced Scorecard – Key Performance Indicators (KPIs)
CUSTOMER PERSPECTIVE
FINANCIAL PERSPECTIVE

 Revenue growth  Image/reputation of the

 Cost management company
 Productivity increases  Customer relations
 Market share

INTERNAL BUSINESS LEARNING AND GROWTH

PROCESSES PERSPECTIVE PERSPECTIVE

 Innovation  Employee training/morale

 Doing things better  Infrastructure for future
 Quality growth
 Efficiency  Research and development

Drury, pp. 564 - 576

 PERFORMANCE MEASURES

Performance Measure Understand Calculate

and explain
Return on Investment (ROI) X X
Residual Income (RI) X X

Economic Value Added (EVA) X -

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