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«Paul M. Collier Aston Business School, Aston University Accounting for Managers Accounting for Managers: Interpreting accounting information for ...»

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Conclusion: a critical perspective In this chapter we have introduced strategy and the role of investment appraisal in capital investment decisions. In particular, we have described the main methods of capital investment appraisal. Often, however, decisions are made subjectively and then justified after the event by the application of financial techniques. This is particularly so for emergent strategy, described earlier in this chapter. Despite the usefulness of these techniques, the assumption has been that future cash flows can be predicted with some accuracy. This is, however, one of the main difficulties in accounting, as we will see in Chapter 14.

Shank (1996) used a case study to show how the conventional NPV approach was limited in high-technology situations as it did not capture the ‘richness’ of the investment evaluation problem. Shank saw NPV more as a constraint


than a decision tool because it was driven by how the investment proposal was framed. Shank argued that a strategic cost management approach (see Chapter 4 for a description of strategic management accounting) could apply value chain analysis, cost driver analysis and competitive advantage analysis to achieve a better fit between investment decisions and business strategy implementation.

References Ansoff, H. I. (1988). The New Corporate Strategy. New York, NY: John Wiley & Sons.

Kaplan, R. S. and Norton, D. P. (2001). The Strategy-Focused Organization: How Balanced Scorecard Companies Thrive in the New Business Environment. Boston, MA: Harvard Business School Press.

Mintzberg, H. and Waters, J. A. (1985). Of strategies, deliberate and emergent. Strategic Management Journal, 6, 257–72.

Porter, M. E. (1980). Competitive Strategy: Techniques for Analyzing Industries and Competitors.

New York, NY: Free Press.

Porter, M. E. (1985). Competitive Advantage: Creating and Sustaining Superior Performance.

New York, NY: Free Press.

Quinn, J. B. (1980). Strategies for Change: Logical Incrementalism. Homewood, IL: Irwin.

Shank, J. K. (1996). Analysing technology investments – from NPV to strategic cost management (SCM). Management Accounting Research, 7, 185–97.


Appendix: Present value factors Table 12.10 gives the present value of a single payment received n years in the future discounted at an interest rate of x% per annum. For example, with a discount rate of 6% a single payment of £100 in five years’ time has a present value of £74.73 (£100 ×.7473).

–  –  –

Performance Evaluation of Business Units This chapter describes the methods by which the performance of divisions and their managers is evaluated. It builds on the foundation established in Chapter 2, which explained how divisionalized business structures have evolved to implement business strategy. We also consider controllability and the transfer pricing problem and introduce the theory of transaction cost economics. This chapter suggests that some techniques may provide an appearance rather than the reality of ‘rational’ decision-making.

The decentralized organization and divisional performance measurement The evaluation of new capital expenditure proposals is a key element in allocating resources by the whole organization (see Chapter 12). However, a further aspect of strategy implementation is improving and maintaining divisional performance.

Businesses may be organized in a centralized or decentralized manner. The centralized business is one in which most decisions are made at a head office level, even though the business may be spread over a number of market segments and geographically diverse locations. Decentralization implies the devolution of authority to make decisions. Divisionalization adds to decentralization the concept of delegated profit responsibility (Solomons, 1965). We introduced the notion of divisional structures and responsibility centres in Chapter 2.

Divisionalization makes it easier for a company to diversify, while retaining overall strategic direction and control. Performance improvement is encouraged by assigning individual responsibility for divisional performance, typically linked to executive remuneration (bonuses, profit-sharing, share options etc.).

Shareholder value is the criterion for overall business success, but divisional performance is the criterion for divisional success. However, divisional performance measurement has also moved beyond financial measures to incorporate the drivers of financial results, i.e. non-financial performance measures (see Chapter 4).

Solomons (1965) highlighted three purposes for financial reporting at a divisional level:


1 To guide divisional managers in making decisions.

2 To guide top management in making decisions.

3 To enable top management to appraise the performance of divisional management.

The decentralization of businesses has removed the centrality of the head office with its functional structure (marketing, operations, distribution, finance etc.).

Instead, many support functions are now devolved to business units, which may be called subsidiaries (if they are legally distinct entities), divisions, departments etc. For simplicity, we will use the term divisionalization although the same principle applies to any business unit. This divisionalization allows managers to have autonomy over certain aspects of the business, but those managers are then accountable for the performance of their business units. Divisionalized business

units may be:

ž Cost centres – where managers are responsible for controlling costs within budget limits. Managers are evaluated on their performance compared to budget by keeping costs within budget constraints.

ž Profit centres – where managers are responsible for sales performance, achieving gross margins and controlling expenses, i.e. for the ‘bottom-line’ profit performance of the business unit. Managers are evaluated on their performance compared to budget in achieving or exceeding their profit target.

ž Investment centres – where managers have profit responsibility but also influence the amount of capital invested in their business units. Managers are evaluated based on a measure of the return on investment made by the investment centre.

Budgets and performance against budget are the subjects of Chapters 14 and 15.

Evaluating divisional performance in comparison to a strategic investment is the subject of this chapter.

Solomons (1965) identified the difficulties involved in measuring managerial performance. Absolute profit is not a good measure because it does not consider the investment in the business and how long-term profits can be affected by short-term decisions such as reducing research, maintenance and advertising expenditure.

These decisions will improve reported profits in the current year, but will usually have a detrimental long-term impact. The performance of divisions and their managers can be evaluated using two methods: either return on investment or residual income.

Return on investment

The relative success of managers can be judged by the return on investment (or ROI, which was introduced in Chapter 7). This is the rate of return achieved on the capital employed and was a method developed by the DuPont Powder Company early in the twentieth century. Using ROI, managerial and divisional success is judged according to the rate of return on the investment. However, a problem


with this approach is whether a high rate of return on a small capital investment

is better or worse than a lower return on a larger capital. For example:

–  –  –

Division B makes a higher profit in absolute terms but a lower return on the capital invested in the business. Solomons (1965) also argued that a decision cannot be made about relative performance unless we know the cost of capital.

Residual income A different approach to evaluating performance is residual income, which takes into account the cost of capital. Residual income (or RI) is the profit remaining after deducting the notional cost of capital from the investment in the division. The RI approach was developed by the General Electric Company and more recently has been compared with Economic Value Added (EVA, see Chapter 2), as both methods deduct a notional cost of capital from the reported profit. Using the

above example:

–  –  –

As the cost of capital is 17.5% in the above example, Division A makes a satisfactory return but Division B does not. Division B is eroding shareholder value while Division A is creating it.

The aim of managers should be to maximize the residual income from the capital investments in their divisions. However, Solomons (1965) emphasizes that the RI approach assumes that managers have the power to influence the amount of capital investment. Solomons argued that an RI target is preferred to a maximization objective because it takes into account the differential investments in divisions, i.e. that a larger division will almost certainly produce – or should produce – a higher residual income. Johnson and Kaplan (1987) believe that the

residual income approach:

overcame one of the dysfunctional aspects of the ROI measure in which managers could increase their reported ROI by rejecting investments that yielded returns in excess of their firm’s (or division’s) cost of capital, but that were below their current average ROI. (p. 165)


One of the main problems in evaluating divisional performance is the extent to which managers can exercise control over investments and costs charged to their responsibility centres.

Controllability The principle of controllability, according to Merchant (1987, p. 316), is that ‘individuals should be held accountable only for results they can control’ (p. 336).

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. The need for the company as a whole to make a profit demands that corporate costs be allocated to divisions so that these costs can be recovered in the prices charged.

The problem arises when a division’s profit is not sufficient to cover the head office charge (we introduced this concept in relation to segmentation in Chapter 8).

Solomons (1965) argued that so long as corporate expenses are independent of divisional activity, allocating corporate costs is irrelevant because a positive contribution by divisions will cover at least some of those costs.

Solomons separated these components in the divisional profit report, a simplied version of which is shown below:

–  –  –

While the business as a whole may consider the operating profit to be the most important figure, performance evaluation of the manager can only be carried out based on the controllable profit. The controllable profit is the profit after deducting expenses that can be controlled by the divisional manager, but ignoring those expenses that are outside the divisional manager’s control. What is controllable or non-controllable will depend on the circumstances of each organization. Solomons argued that the most suitable figure for appraising divisional managers was the controllable residual income before taxes. Using this method, the controllable profit is reduced by the corporate cost of capital. For decisions in relation to a division’s performance, the relevant figure is the net residual income after taxes.

One of the problems with both the ROI and RI measures of divisional performance is the calculation of the capital investment in the division: should it be total (i.e. capital employed) or net assets (allowing for gearing)? Should it include fixed or current assets, or both? Should assets be valued at cost or net book value? Should the book value be at the beginning or end of the period? Solomons (1965) argued that it was the amount of capital put into the business, rather than what could be


taken out, that was relevant. The investment value, according to Solomons, should be total assets less controllable liabilities, with fixed assets valued at cost using the value at the beginning of the period. ROI calculations therefore relate controllable operating profit as a percentage of controllable investment. An RI approach would measure net residual income plus actual interest expense (because the notional cost of capital has been deducted in calculating RI) against the total investment in the division.

The following case study provides an example of divisional performance measurement using ROI and RI techniques.

Case study: Majestic Services – divisional performance measurement Majestic Services has two divisions, both of which have bid for £1 million for projects that will generate significant cost savings. Majestic has a cost of capital of 15% and can only invest in one of the projects.

The current performance of each division is as follows:

–  –  –

Each division has estimated the additional controllable profit that will be generated from the £1 million investment. A estimates £200,000 and B estimates £130,000.

Each division also has an asset of which they would like to dispose. A’s asset currently makes a return on investment (ROI) of 19%, while B’s asset makes an ROI of 12%. The business wishes to use ROI and residual income techniques to determine in which of the £1 million projects Majestic should invest, and whether either of the division’s identified assets should be disposed of.

Using ROI, the two divisions can be compared as in Table 13.1. While Division B is the larger division and generates a higher profit in absolute terms, Division A achieves a higher return on investment.

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