In a divisional organisation, head office management needs to evaluate the performance of its divisions. This article discusses three measures which could be used to measure divisional financial performance – Return on investment (ROI), residual investment (RI) and economic value added (EVATM) – and assesses the advantages and disadvantages of each. The article also discusses the importance of distinguishing between divisional performance and managerial performance
Many large organisations have divisionalised structures. In these organisations, a vital part of the head office management’s role is measuring the performance of the divisions and of divisional managers.
In this context, it is important to recognise the distinction between divisional performance and managerial performance. An important question is the extent to which a manager’s performance should only be evaluated in relation to factors they can control, rather than the overall performance of their division.
Another key question relates to the choice of measure (or measures) which are used to assess performance; in particular, return on investment (ROI), residual income (RI) or economic value added (EVATM).
This article will focus on financial performance measures: how different measures are used to assess performance, and the advantages and disadvantages of the different measures. However, if an organisation focuses only on financial measures this be an underlying disadvantage because it overlooks the non-financial factors – market position, productivity, quality, and innovation – which could contribute to its longer-term success.
You should already be familiar with the characteristics of good divisional performance measures from your studies of Performance Management at Applied Skills:
The issue of goal congruence, in particular, will be important in relation to the advantages and disadvantages of the different methods. But first the importance of controllability when assessing what aspects of performance are measured will be considered.
As mentioned in the introduction, it is important to distinguish between a division’s performance and its manager’s performance. The issue of controllability is key to this: managers should only be assessed in relation to aspects of performance they can control, whereas a division should be assessed in relation to its overall performance.
In turn, the importance of controllability highlights the need to distinguish between controllable and traceable costs, and therefore controllable and traceable profit.
Controllable costs are those which are controllable by the manager of the division.
Traceable costs include controllable costs plus other costs directly attributable to a division, but which the manager doesn’t control.
When assessing the divisional manager’s performance, only those items which are controllable by the manager should be included in the performance evaluation. Expenditure relating specifically to the division but agreed by head office – not by the divisional manager – should be treated as traceable costs, not controllable ones. For example, marketing fees relating to the division but agreed by the Head Office marketing director (not the divisional manager) are traceable, not controllable. Similarly, legal fees or audit fees relating to the division but agreed by head office.
Controllable profit should be used to assess the manager’s performance, while traceable profit should be used to assess the division’s performance.
However, there is a further distinction to recognise: that between traceable and divisional profit:
Traceable profit should exclude overhead costs which are incurred centrally and then re-apportioned to a division. These costs are provided by head office for the benefit of multiple divisions, rather than relating directly to one division (eg central marketing services, HR, IT or finance).
|Costs controlled by divisional manager|
|Divisional costs, not controlled by divisional manager|
|Allocated head office costs|
Recognising the share of head office costs is important though in order to reflect the costs the division would have to incur if it were independent. If divisional performance is assessed on only traceable profit it is likely to be overstated compared to an external competitor. If the division were a separate company, it would have to incur some of the corporate costs itself (for example, HR, IT, finance costs, which are incurred by head office within a group structure). As such, a company should use divisional profit to compare the performance of one of its divisions to that of an external company.
EXAMPLE 1 – Controllable, traceable and divisional profit
Consider the following information about a division’s revenue and costs for the last year:
|Variable costs (controlled by divisional manager)||286|
|Fixed costs (controlled by divisional manager)||137|
|Apportioned head office costs||43|
Marketing campaigns are controlled by the head office, but relate specifically to the division’s products.
Based on this information, calculate controllable, traceable and divisional profit for the last year:
|Variable costs (controlled by divisional manager)||286|
|Fixed costs (controlled by divisional manager)||137|
|Apportioned head office costs||43|
Although in Example 1 , costs which are ‘controllable’ and those which aren’t are distinguished, this distinction can be more difficult to make in practice, with some costs being partially controllable. For example, costs of raw materials could be afffected by supply shortages outside a manager’s control. However, a manager could take action to reduce the adverse impacts of a price change by trying to substitute alternative materials.
Equally, some traceable costs (such as the marketing campaigns in Example 1) could contribute to a division’s revenue. As such, if all of the division’s revenue is considered to be ‘controllable’, but not all of the costs are, the manager’s performance (ie controllable profit) will be over-stated. However, the difficulty in such a situation is assessing how much revenue relates directly to the non-controllable cost and should therefore be deducted from divisional revenue to make a ‘like for like’ comparison of controllable costs and revenues, which would more fairly assess the manager’s performance.
One potential solution to the issue of classifying controllable and non-controllable factors is to specify which budget lines are to be regarded as controllable and which are not.
The issue of ‘controllability’ is important because it will affect the figures used in any performance measurement calculations depending on whether it is a division or a manager whose performance is being assessed. However, perhaps an even more important consideration for corporate management is which performance measures they use in order to make that assessment.
Two commonly used measures of divisional performance are return on investment (ROI) and residual income (RI).
Return on investment (ROI): measures operating profit as a percentage of the assets employed in the division. ROI needs to be greater than the cost of capital for a division to be profitable in the long term.
ROI (%) = Traceable (controllable*) profit / Traceable (controllable*) investment
*: If manager’s performance is being assessed, rather than the division’s, ROI should be based on ‘controllable’ figures, not ‘traceable’ ones.
Residual income (RI): the income that the division is earning less a cost of capital charge (imputed interest) on the assets employed in the division.
RI = Traceable (controllable) profit – imputed interest** on traceable (controllable) investment
**: Imputed interest is calculated by multiplying the traceable (or controllable) investment by the cost of capital. This is typically the weighted average cost of capital (WACC). However, instead of using WACC, a company might also set a target rate of return on the capital provided. In such a situation, a positive RI will indicate a division is generating a level of return greater than the target.
As our focus here is on divisional performance measurement, we are using looking at ROI rather than ROCE. The two are very similar, but ROCE would be more appropriate for looking at a company as a whole or at the division when treating it as if it were an external company or against an external company. In this case we would use divisional profit
Return on capital employed (ROCE): measures how efficiently a company/division uses its capital to generate profits.
ROCE (%) = Profits before interest and tax (or divisional profit)
(where Capital employed = total assets minus current liabilities)
ROCE should be greater than the cost of capital for a company to be profitable over the long-term.
ROCE can be useful for comparing the use of capital by different companies or divisions engaged in the same business. However, the value of any comparison (ROCE; ROI) will be affected by the similarities (or differences) between the entities whose performance is being measured. For example, ROCE is most useful when comparing performance between companies in the same industry, but its usefulness will be reduced if there are significant differences in the industry, or competitive environment, in which companies are operating).
EXAMPLE 2 – Calculating ROI and RI
A company has two divisions, Division A and Division B.
In the second half of 20X2, Division B launched a new product. It has invested $50 million in new machinery needed to manufacture that product. The company’s marketing department spent $14 million on a major marketing campaign (on behalf of Division B) to accompany the product launch.
The divisional results for the last two financial years (20X1 and 20X2) show:
|Divison A||Division B|
|Apportioned head office costs||17||16||22||20|
The company’s weighted average cost of capital is 10%, and management believe this is appropriate for both divisions.
(i) Based on this information, calculate ROI and RI for both divisions for 20X1 and 20X2, using traceable profit.
(ii) Comment on the usefulness of ROI and RI in assessing the performance of Division B in 20X2.
Return on investment
|Divison A||Division B|
|Add back apportioned head office costs||17||16||22||20|
|Divison A||Division B|
|Imputed interest charge (Capital employed x WACC)||19.5||20.0||28.5||23.0|
Both measures suggest that Division B’s performance appears to have deteriorated significantly in 20X2, so that it is now performing worse than Division A, although it appeared to be performing better than Division A in 20X1.
However, this is due to the new investment for the new product launch and the associated marketing expenditure. The $50 million capital investment in new machinery has increased the capital employed, while the company’s marketing expenditure increased traceable costs.
However, the product was only launched in the second half of the year, so Division B’s revenue does not fully reflect the benefits from selling the product yet. Moreover, provided the new product is successful we could expect it to continue to generate additional revenues in subsequent years.
Given investment in new equipment, it would be better to use an average capital employed figure for Division B:
|Average capital employed (230 + 285)/2||257.5|
Using this average, Division B’s RI is now greater than Division A’s, although it is still significantly lower than it was in 20X1. Even using the average, Division B’s ROI is still lower than Division A’s in 20X2.
This illustrates one of the major potential problems with ROI and RI as performance measures: encouraging short-termism.
Investing in new capital has seemingly made Division B’s performance worse. Therefore, a manager might choose not to invest in new assets, to avoid the apparent negative impact on performance. However, not investing in new assets in the short term could be damaging to a division’s competitive performance in the longer term. As such, using ROI and RI as performance measures could encourage dysfunctional decision-making, rather than promoting goal congruence (one of the key characteristics of effective performance measures).
More generally, this example also illustrates a wider potential issue in performance measurement (regardless of the specific measures), being the validity of comparisons between different entities.
Comparisons of performance are most useful when the divisions (or companies) being compared are similar. In this case, the issue is that one division has had a significant increase in capital employed while the other hasn’t.
However, there could be a range of other issues which could reduce the validity of comparisons: for example, relative age of assets (and therefore the amount of accumulated depreciation reducing net book value); assets held at cost compared to assets which have been revalued; differences between the industries in which divisions operate (and differences in their potential for growth and profit).
As mentioned earlier one of the key characteristics of effective divisional performance measures it that they encourage goal congruence. However, using ROI to evaluate division performance can lead to sub-optimal (or dysfunctional) decision-making.
The company in Example 2 has a cost of capital of 10%. Therefore, projects which generate a return of greater than 10% will have a positive net present value and should be undertaken, because they will increase the overall value of the company in the future.
However, consider a situation where Division A from Example 2 had an opportunity in 20X2-3 to invest in a project with an expected return of 12%. If ROI is used as the main performance measure, the manager of Division A would be likely to reject the project because the return is lower than the division’s current ROI (15.9%), so undertaking will reduce divisional ROI.
This is one of the key disadvantages of ROI: that divisional managers may decide not to undertake a project with a return in excess of the cost of capital, because it has a lower ROI than the division’s current ROI.
The conventional wisdom is that, to help overcome this problem, companies should use RI as their measure of performance rather than ROI.
In the hypothetical situation facing the Manager of Division A, the choice of performance measure being used could affect the manager’s decision:
ROI: Won’t invest
Current ROI = 15.9%. Expected rate of return on new project: 12%. Manager won’t invest because expected return is below current ROI, so investing will reduce the division’s ROI.
RI: Will invest
Target rate of return (WACC) = 10%. Expected rate of return on new project: 12%. Manager will invest, because RI is positive (ie expected rate > target rate).
In this respect, RI is a better measure to use because it encourages decision-making which is consistent with the logic of net present value (NPV), which is considered the best method of investment appraisal because it looks at the value which will be generated for shareholders if a project is undertaken.
Another potential advantage of using RI instead of ROI is that it is more flexible: different costs of capital can be applied to different divisions or investments to reflect differing levels of risk.
However, there are also problems with using RI:
Difficulty in estimating cost of capital – it can be difficult to estimate the cost of capital (or to calculate the required return from a project). However, the imputed interest charge is vital to the RI calculation.
The cost of capital should include cost of equity as well as cost of debt. In practice, investment centres are often only charged the debt portion of corporate capital, which understates the true cost of the centre’s capital.
Comparing performance between divisions – to compare the performance of different divisions, a measure needs to take into account variations in size or differing levels of investment. ROI enables this, because it shows percentages, so can be used to compared returns on divisions of different sizes. By contrast, RI is an absolute measure, which makes it difficult (but not impossible) to compare performance.
• Comparable – easy to compare performance between divisions (or companies of different sizes) because it provides a ratio (%) rather than an absolute value
• May encourage dysfunctional decision-making – eg not investing in an opportunity whose return is greater than WACC, because the projected return is less than existing ROI
• Likely to encourage short-termism
*: The advantages and disadvantages of using ROCE as a performance measure are the same as for ROI.
• Goal congruence – If RI of an investment is positive, then the investment will be undertaken.
• Ties into the logic of NPV
• Flexibility – can use different costs of capital to reflect levels of risk
• Absolute values – use of absolute values rather than % makes it harder to compare performance between divisions of different sizes.
• Difficulty in estimating cost of capital
There are also potential problems which are common to both ROI and RI:
This point about reducing the impact of different accounting policies (and reducing the impact of accounting adjustments and estimates) is part of the rationale behind economic value added (EVATM) as an alternative method of performance measurement to ROI or RI.
EVATM is a performance evaluation tool developed, and trade-marked, by Stern Stewart & Co consultants. The rationale behind it is similar to RI, in that a finance charge is deducted from profits in order to identify value added.
The calculation of EVATM can be summarised as:
Net operating profit after tax (NOPAT)
Cost of capital charge (WACC) on divisional assets
Economic value added
However, a major difference between EVATM and RI is the adjustments made to reported finacial profits and capital in EVATM. Proponents of EVA argue that accounting profits – calculated in accordance with financial reporting principles – do not reflect the economic value generated for shareholders by a company.
As such, a number of adjustments need to be made to assess performance on economic profit rather than accounting profit. These adjustments result in:
Economic value added is discussed in more detail in two separate articles:
The focus on economic profit rather than accounting profit makes EVATM better aligned to companies’ objectives of maximising shareholder wealth. However, EVATM still depends on historical data, while shareholders are ultimately concerned with future performance, and future cash flows.
Capitalising value-building expenditure and spreading the cost over the periods in which the benefits from it are received, should reduce short-termist decision-making. For example, under EVATM, the marketing expenditure linked to the launch of Division B’s new product in our Example 2, would be capitalised, rather than expensed in 20X2.
Similarly, using the gross book value of assets (rather than net book value) should make it less attractive for managers to delay replacing old assets, whereas under ROI or RI managers can appear to improve performance in the short term by operating with older assets with a low written-down value.
EVATM, like RI, is an absolute measure, so it will have limited value in judging the relative performance of divisions (or companies) of different sizes.
The number of adjustments needed to convert from accounting profit to NOPAT and therefore the time taken to calculate EVATM.