by Performance measurement is the performance based management process which is flowing from the organizational mission and the strategic planning process. Divisional performance measurement includes the objective and subjective assessments of the performance sub-units of an organization such as divisions or departments. Divisional performance measurement are effective in ensure that a strategy of organization is successfully implemented by monitor a divisions effectiveness in satisfying its own predetermined goals or stakeholder desires. Divisional performance measures may be based on non-financial as well as on financial information.
Measurement of Divisional Performance
Method 1. Return on Investment (ROI)
Many organizations use return on investment (ROI) to measure divisional performance. ROI expresses divisional profit (operating profit) as a percentage of assets employed in the division. Some companies use net profit after tax as the numerator in calculating the ROI.
Deciding on the denominator is a complex decision. Many companies allocate corporate equity to different divisions on some equitable basis (e.g., proportion of total assets employed in each division) and use the same as a denominator.
Some firms use capital employed, (i.e. fixed assets + working capital) as the denominator. However, considerable variations are found in practice on how working capital is treated. Many firms use gross working capital particularly if divisional managers have no influence on trade creditors or other current liabilities. Others prefer to use net working capital as it provides a good measure of corporate resources allocated to the business, and managers are expected to earn an adequate return on the same.
Many organizations use book value of fixed assets in calculating capital employed in the division. However, use of book value often misstates the division profitability. Use of book value reduces capital employed and increases ROI every successive year without any real improvement in economic performance. Therefore, use of book value may not motivate divisional manages to acquire new fixed assets.
Better alternatives are the use of replacement cost or the original cost of acquisition (gross book value). However, use of replacement cost or original cost presents some practical problems because it is difficult to ascertain replacement costs of different assets acquired at different points of time having different residual values. If original cost of an asset is used managers may be motivated to dispose of assets even if they have some usefulness.
Companies prefer to use net book-value methods in preference to others because non-accounting methods have an element of subjectivity, while financial accounting methods have an aura of reality for operating managers. The selection of a particular method ultimately depends on the assessment of corporate management of what practice would induce divisional managers to efficiently use resources and to acquire proper amount and kind of new assets.
The following are the advantages of ROI for measuring divisional performance:
(a) It is a comprehensive measure and captures all the factors which influence figures in financial statements.
(b) It is easy to calculate and understand.
(c) It makes comparison of performances of different divisions easy.
(d) Data on ROI of different companies are easily available and that helps in inter-firm comparison.
In spite of these advantages many companies do not use ROI for measuring divisional performance because it has the potential to create serious dysfunctional effect.
Use of ROI may motivate divisional managers to avoid acquisition of assets which would decrease the ROI of the division even though it would improve the performance of a company as a whole. E.g., if the current ROI of a division is 20% it would not acquire an asset which would earn a return of 18% although the weighted average cost of capital of the company is 15%.
Thus ROI creates a bias towards no or little additional investment. Managers may also take wrong asset disposal decisions. Similarly, a division which has a very low ROI may be tempted to improve ROI by acquiring assets which will improve its ROI although its earning will be lower than the cost of capital of the company.
In view of this serious limitation, many companies use ‘RI’ as a measure of divisional performance.
Method 2. Residual Income (RI) or Economic Value Added (EVA)
Residual Income is pre-tax profit less an imputed interest charge for invested capital.
The imputed interest charge is often referred to as capital charge in management literature. This capital charge is found by multiplying the amount of assets employed by a rate. Selecting the rate of capital charge also poses some problems.
The simplest method is to use company’s cost of capital. However, a sophisticated method uses different rates for different classes of assets may be one rate for general-purpose assets, while a special rate for special-purpose assets.
Some companies use a rate which is close to the company’s cost of borrowing rather than to its cost of capital.
While ROI is a ratio, RI is an absolute figure. RI deals with the problems of ROI adequately because any investment, which will earn higher than the capital charge will improve the RI. Therefore, use of RI motivates divisional managers to acquire only those assets, which will improve the performance of the company as a whole. Thus, the RI method sets the same profit objective for same assets in different divisions.
A sophisticated system also solves the problem of the same profit objective for different assets in the same division by using different rate of capital charges for different class of assets. RI is definitely a superior measure compared to ROI for measuring divisional performance.
Stern Steward & Co., a consultancy firm in USA, uses the term EVA for RI. The Stern Steward & Co. suggests many adjustments to correct the distortions in reported profit and capital due to accounting bias towards prudence. Many firms use EVA as the basis for calculating variable part of the executive compensation to induce managers to behave like owners, who in a business to create wealth for themselves.
