Chapter 15 Divisional Performance Measures Answer 1 a Performance statistics The performance of store W can be assessed in various ways Sales Growth Sales revenue gro by 6Z5NvUA


									               Chapter 15 Divisional Performance Measures

Answer 1
Performance statistics

The performance of store W can be assessed in various ways:
Sales Growth
Sales revenue growth is most unimpressive. We are told that the market in which PC
operates is steadily growing and yet store W has shrunk in terms of sales over the last
four years. This could be poor volumes or poor prices achieved. Given the reducing
gross margin (see below), then a reducing sales price is likely. It is possible that W is
subject to higher than normal levels of competition.

Gross Margin
The gross margins have also shrunk. Reducing margins can result from sales price
pressure or increases in the cost of sales levels being incurred. Suppliers might have
increased prices or labour could have got more expensive. The level of margin has
only reached the normal level once in the last four years. Clearly W is under

Overhead Control
The one area that is impressive is the apparent ability of the business to reduce
overheads as sales and margin have shrunk. This is often difficult to do. It is possible
that reducing these overheads could have contributed to the poor sales performance, if
(for example) quality has been affected, or one could say it reflects flexible

Net Margin
The net margin has also fallen, primarily due to falling gross margins as overheads
have reduced. Clearly a disappointing performance.

The ROI has improved in most years and has exceeded the 15% target in all but one

                                           P. 1
year (year 1). This is simply due to the reducing asset base as the stores assets have
gradually been depreciated. Net profit levels have fallen overall and yet ROI has

It is hard to argue that the ROI figures properly reflect the performance of the store.
The ROI will tend to increase as assets get older and this will distort the financial
performance picture. In a period of falling sales and weaker margins the manager of
W has been awarded bonuses in three out of four years. This is hard to justify.

The unethical manager would have needed to move profits out of 2006 and in to 2005.
One immediate problem here is having the information in good time to respond. The
manager would have to be able to anticipate the 2005 poor result and the
improvement in 2006. It is likely that such a manager would have to gamble at the
end of 2005 and make an adjustment in the hope of a better year in 2006.

The manager need only move $2,000 of profit from 2006 to 2005 to achieve a 15%
return in both years.

Possible methods of adjustment include:
Accelerate revenue: Sales made early in 2006 could be wrongly included in 2005. He
could, for example, raise an invoice before is normal, perhaps on the receipt of an
order and before actual delivery. The invoice itself would not have to be sent to the
customer, merely filed until the second year had begun and delivery made.

Delay the recording of 2005 cost: A supplier’s invoice could be left unrecorded at
the end of 2005, including it in 2006 expenses instead.

Understate a provision or accrual in 2005: This has the effect of moving cost from
2005 to 2006 (assuming that by the end of 2006 the provision is correctly stated).

Manipulate accounting policy: Inventory values (for example) are easy targets for
the unethical manager. If inventory in 2005 could be overstated this would have the
effect of increasing 2005 profits at the expense 2006 profits.

                                          P. 2

Alternatively, given that variable costs are said to be constant over the four years,
could calculate the variable cost in year one and hold for the four years. Gross profit
is then simply sales revenue less variable costs.

Variable costs in 2005:
$216,000 – 18,000 x VC = $86,400
VC per unit = $7·20
So year two gross profit will be:
$237,600 – 19,800 x 7·2 = $95,040

In order for a bonus to be paid in 2012 an ROI of 15% is needed. This implies a net
profit of $25,000 x 15% = $3,750.

Adding overheads of $80,000 to this net profit means that $83,750 of gross profit is
needed. At a gross profit % of 33·518% this implies sales of $249,866.

                                          P. 3
At a price of $10·83 this suggests sales volume of 23,072 units.

Answer 2

The only difference would be to add the fixed costs and adjust the mark-up %.

The price difference is therefore 12·87 – 11·31 = $1·56 per unit

As far as the manufacturer is concerned, including fixed costs in the transfer price will
have the advantage of covering all the costs incurred. In theory this should guarantee
a profit for the division (assuming the fixed overhead absorption calculations are
accurate). In essence the manufacturer is reducing the risk in his division.

The accounting for fixed costs is notoriously difficult with many approaches possible.
Including fixed costs in the transfer price invites manipulation of overhead treatment.

One of the main problems with this strategy is that a fixed cost of the business is
being turned into a variable cost in the hands of the seller (in our case the stores). This

                                            P. 4
can lead to poor decision-making for the group since, although fixed costs would
normally be ignored in a decision (as unavoidable), they would be relevant to the
seller because they are part of their variable buy in price.

Degree of autonomy allowed to the stores in buying policy.
If the stores are allowed too much freedom in buying policy Hammer could lose
control of its business. Brand could be damaged if each store bought a different
supplier’s shears (or other products). On the other hand, flexibility is increased and
profits could be made for the business by entrepreneurial store managers exploiting
locally found bargains. However, the current market price for shears may only be
temporary (sale or special offer) and therefore not really representative of their true
market ‘value’. If this is the case, then any long-term decision to allow retail stores to
buy shears from external suppliers (rather than from Nail) would be wrong.

The question of comparability is also important. Products are rarely ‘identical’ and
consequently, price differences are to be expected. The stores could buy a slightly
inferior product (claiming it is comparable) in the hope of a better margin. This could
seriously damage Hammer’s brand.

Motivation is also a factor here, however. Individual managers like a little freedom
within which to operate. If they are forced to buy what they see as an inferior product
(internally) at high prices it is likely to de-motivate. Also with greater autonomy, the
performance of the stores will be easier to assess as the store managers will have
control over greater elements of their business.

Answer 3

                                           P. 5
Return on investment figures indicate that the CS sector is the most successful but this
reflects the much lower level of capital employed in a consultancy business compared
to manufacturing companies.

Residual income figures indicate that the HE sector is the most successful, reflecting
the high level of profits that it generates.

(i) Return on investment (ROI) is intended to measure the efficiency with which
    assets are being used, by taking the profit as a proportion of the net assets.
       Residual income (RI) on the other hand, is simply the profit reduced by a
       financing charge which is based on the net assets. RI is an absolute, not a
       relative measure.
(ii)   ROI has the major advantage of taking full account of the size of the business,
       so that businesses of different sizes can be compared. Residual income, on the
       other hand, may be less distorted by inappropriate values for investment.

The problem is to decide which sector to expand. While recent results are of course
relevant to such a decision, the information given in the question is inadequate for the
following reasons.
(i) Results for earlier years are not given. Some of the results for 20X1 could be out
      of line with normal results.
(ii) Non-current and current assets are not analysed by type of asset, nor is any
      indication given of the remaining lives of non-current assets.
(iii) A single rate is used for the group finance charge, without any account being
      taken of the business risk of each sector.
(iv) All the information provided comes from the group's accounting system. It
      makes no reference to the open market values of whole businesses or of
      individual assets.

The following further information would be useful.
(i) An analysis of non-current assets by type and by likely time to replacement.
(ii) An analysis of current assets into inventory, receivables and cash.
(iii) Results for at least the two previous years, adjusted for inflation so as to be
      comparable with the 20X1 results.
(iv) Expected results for 20X2, together with a clear statement of the assumptions

                                          P. 6
     used in preparing the forecasts.
(v) The market share of each sector.
(vi) The extent to which the results include intra-group transactions, and the bases on
     which prices for such transactions are determined.

Fitzgerald and Moon's building blocks for dimensions, standards and rewards attempt
to overcome the problems associated with performance measurement of service
businesses. They would therefore be particularly useful for the CS sector. Certain
elements may also be worth considering for HE and LE.

Performance measurement in service businesses has sometimes been perceived as
difficult because of factors such as the intangibility, inseparability, heterogeneity and
perishability of services.

The modern view is that if something is difficult to measure this is because it has not
been clearly enough defined. Hence Fitzgerald & Moon provide building blocks for
performance measurement systems in service businesses.

Three questions are asked: What dimensions of performance should be measured?
How should standards be set for those measures? What rewards should be associated
with the achievement of these standards?

Three issues need to be considered if the performance measurement system is to
operate successfully: clarity, motivation and controllability.

(i)   The organisation's objectives need to be clearly understood by those whose
      performance is being appraised ie they need to know what goals they are
      working towards.
(ii) Individuals should be motivated to work in pursuit of the organisation's strategic
      objectives. Goal clarity and participation have been shown to contribute to
      higher levels of motivation to achieve targets, providing managers accept those
      targets. Bonuses can be used to motivate.
(iii) Managers should have a certain level of controllability for their areas of
      responsibility. For example they should not be held responsible for costs over
      which they have no control.

The building block framework will therefore be particularly useful for the CS sector

                                           P. 7
but aspects can also be used throughout the group to measure how well corporate
objectives are being achieved and highlighting where improvements are needed.

Answer 4
The following conditions are necessary for the successful introduction of such centres.
(i)      The centres must have a measurable output. This does not mean that the
         output must necessarily be sold on the external market. It may be transferred
         internally for use in another part of the organisation. In this case the 'revenue'
         generated is determined by the use of a transfer price.
(ii)  It must be possible for the centre manager to exercise control over the level
      of output.
(iii) For an investment centre, it must be possible for the centre manager to
      exercise control over the level of investment in the centre, and for the level of
      investment to be measured objectively.
(iv) A reporting system must be established which provides rapid and accurate
      feedback to keep centre managers informed about their performance.
(v)      Centre managers must accept the change and must be willing to accept the
         extra responsibility associated with their new role. Provision must be made for
         adequate education and training in the operation of the new responsibility
         accounting system.
(vi) Central management must also fully understand and accept the new system,
     particularly if they are required to delegate authority for decisions which they
     are accustomed to making themselves.

Annualised return on investment (ROI)
                                                Y                            Z
Annualised net income before             $122,000 x 12 =           $21,000 x 12 = $252,000
tax                                        $1,464,000
ROI                                     1,464 ,000                     252 ,000
                                                    15 %                         20 %
                                        9,760 ,000                    1,260 ,000

The two divisions Y and Z operate in similar markets. Of the two, Z is the smaller one
in terms of both sales and divisional net assets. Z also has the higher ROI of the two,
being 20% compared to Y's 15%.

However, what is surprising is the different proportion of variable costs in relation

                                             P. 8
to sales for the two divisions. Variable costs constitute 38 percent of sales for Y and
56 percent of sales for Z. We need further information to explain the higher variable
costs of Z. Could these be related to the lower divisional assets? There is a range of
possible explanations here and further investigation will be necessary.

It is possible that division Z's assets are old and lead to inefficiency in production.
Although Z's overall ROI is higher, this may be because its assets are old and do not
reflect the current replacement cost. The results highlight the fundamental problem
with using ROI as a single measurement of performance. ROI can lead to
sub-optimal decisions where a manager is unwilling to undertake further investment
which, although giving a positive return, may reduce the current ROI. This may be the
case with division Z.

There is no indication that division Z is outsourcing part of its production process,
which may have been a possible explanation for higher variable costs and lower
divisional assets. Further investigation is required.

Looking at the secondary performance ratios of profit margin and asset turnover
below, it is easy to see that division Y has the higher profit margin and lower asset

Secondary performance ratios

For division Y

For division Z

We need to look at the relative ages of the assets and their relationship to replacement
cost to be able to assess further the divisional performance. We also need further
information on the basis for apportioning central costs. If only controllable income is

                                          P. 9
assessed as a proportion of divisional net assets, the returns are even more strikingly
different (56.56% for Y and 191% for Z).

Residual income = Accounting profit – Notional interest on capital.

For division Y
RI = ($122,000 × 12) – (12% × $9,760,000) = $1,464,000 – $1,171,200 = $292,800

For division Z
RI = ($21,000 × 12) – (12% × $1,260,000) = $252,000 – $151,200 = $100,800

The absolute score RI is positive for both divisions. This means that sufficient
residual income is left for the shareholders after an imputed interest charge on
divisional assets is deducted from net profit. Whereas the relative measure ROI is
higher for division Z, the absolute measure RI is higher for division Y.

RI is a superior measure technically but no single measure alone is sufficient for a
meaningful performance evaluation. As the cost of capital rises, RI will fall. The
imputed interest charge should be calculated on the replacement cost of assets. It
would appear that here we have assets at historic cost.

ROI is a relative measure expressed in percentage terms. As such it is easy to
understand and can be readily compared against a required benchmark rate.

ROI can lead to sub-optimal decisions. As the case of divisions Y and Z illustrates, it
is not certain whether it is better to have a return of 20% on a $1.2 million investment
or a 15% on a $9.8 million investment.

Shareholders may prefer the former in that less of their funds are tied in the business.
However, the use of ROI may tend to limit growth as a manager assessed on ROI
alone will be unwilling to undertake further investment providing a return lower
than the current one he is earning.

                                          P. 10
Residual Income
Residual income (RI) requires that a capital charge is imputed on each division's
profit. RI does not suffer from the potential problems of ROI as any investment
providing a return in excess of the required rate is likely to be accepted.

The imputed capital charge is based on assets at historic cost. Divisions with older
assets may appear to be doing better in the short term.

Other methods
Other methods of performance assessment are Economic Value Added (EVA®) and
profitability measures such as net profit margin and gross profit margin.

EVA® is similar to RI in that it is an absolute measure. However, EVA® is
considered an improved variant of RI in that it is based on economic and not
accounting profit. Moreover, the capital charge is based on the replacement cost of

Net profit margin is measured as a percentage of net profit to turnover. Gross profit is
measured as a percentage of gross profit to turnover.

Answer 5
Annual profit = external sales revenue + internal sales revenue – variable costs – fixed
Therefore, $564,000 = ((150,000 – 60,000) × $35) + (60,000 × P) – (150,000 × $22) –
$1,080,000, where P = transfer price.
Therefore P = $29.90

                                          P. 11
External sales demand is 110,000 units. Maximum capacity is 150,000 units and so by
transferring 60,000 units internally, external sales of 20,000 units are lost.

The opportunity cost of these 20,000 units = variable cost + contribution lost from
selling externally = $22 + $13 = $35 = external selling price.

The remaining 40,000 units can be produced using space capacity and so opportunity
cost = variable cost = $22.

Current policy
By allowing divisions the freedom to set transfer prices (A sets a price of $29.90) and
choose their suppliers, C will not purchase the 60,000 units from A because it can buy
them cheaper, externally, from X. C is motivated to take such action to maximise the
sole performance measure (RI).

                                          P. 12
1.   A's external contribution will rise by $260,000 with the current policy.
2.   Overall A's contribution will fall by $214,000.
3.   C's costs will fall by $114,000.
4.   Net effect for the group = fall in contribution of $100,000.
5.   In terms of external transactions:
      Increase in external sales             [20,000 x $(35 – 22)]         260,000
      Increase in external costs             [60,000 x $(28 – 22)]         360,000

Proposed policy
C has two options.
(i) Purchase 40,000 units from A at $22 per unit
     Purchase 20,000 units from Z at $33 per unit
     Total cost = $1,540,000
(ii) Purchase 50,000 units from X at $28 per unit
      Purchase 10,000 units from A at $22 per unit
      Total cost = $1,620,000

C would choose the first option in order to minimise costs.
Effect on A

Difference on external sales. Proposed policy increases contribution by 20,000 × $35
= $700,000.
Difference on internal sales. Proposed policy reduces contribution by (40,000 ×
$(29.90 – 22)) + (20,000 × $29.90) = $914,000
Net effect on A. Reduction in contribution of $214,000.
Effect on C. C's costs reduced from $1,794,000 to $1,540,000, a reduction of
Effect on group. Net effect, increase in contribution of $40,000.

In terms of external transactions:

                                         P. 13
 Increase in external sales            [20,000 x $(35 – 22)]         260,000
 Increase in external costs            [20,000 x $(33 – 22)]         220,000

(i) Both policies are flawed in that C can act in its own interests, which might not
     necessarily be in the interests of the group as a whole.
(ii) Of the two policies, the proposed policy is the more advantageous to the group.
(iii) Division C might not have the knowledge to make the correct decision to
      maximise the group's profit.
(iv) To maximise group profit, transfers should be made at marginal cost to ensure
      that C makes the correct decision for the group. This policy has a demotivating
      effect on the management of A, however, as fixed costs are not covered.
(v) ACF group should consider introducing a wide range of performance measures
      and/or qualitative measures to ensure goal congruence and to guard against
      dysfunctional decision-making.

                                        P. 14

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