Divisional Performance Measurement

Table of Contents:-

• Divisional Performance Measurement
• Financial Measures
• Divisional Income
• Return on Investment (ROI)

Divisional Performance Measurement

Performance measurement is the performance-based management process that flows from the organizational mission and the strategic planning process. Divisional performance measurement involves both the subjective and objective assessments of the performance of sub-units within an organization such as departments or divisions. Effective divisional performance measurement ensures the successful implementation of the organization’s strategy by monitoring how well a division meets its predetermined goals or stakeholder desires. Both financial and non-financial information contribute to the derivation of divisional performance measurement.

Divisional performance measurement serves as a vital tool for organizations to measure the performance of individual divisions within their structure. By evaluating the performance of each division or department companies can identify areas of their strength and weakness. It enables them to allocate resources effectively and optimize overall performance.

The objective is to develop performance measurement systems for divisions that serve as important investment centres within large organizations. 

Such systems should:

1. Provide information for economic decisions,
2. Facilitate the control of division operations,
3. Motivate managers to achieve high levels of divisional performance to further the objectives of the entire organization, and
4. Serve as a basis for evaluating and assessing the performance of divisional managers.

Performance measurements of managers play a key role in determining their salaries, bonuses, future assignments, and status, serving as a driving force for their goal attainment. The organization employs divisional performance measurement to assess the performance of managers in specific divisions, as illustrated below:

Financial Measures

Financial performance measures are based on financial performance information both internal and external. For example, profitability, stock prices, etc. It is important to note in this context that financial measures are long-term measures and, needless to mention that it is non-financial measures which affect financial measures in the future.

According to Horngren, Datar, and Foster, – “The enhancement in non-financial measures serves as a strong indicator of future economic value creation, even if the immediate impact on short-term earnings may not be evident. For example, an increase in customer satisfaction, as measured by customer surveys and repeat purchases, is a signal of higher sales and income in the future”.

There are the following ways of relating profits to assets employed, which are as follows:

1. Divisional Income
2. Return on Investment (ROI)
3. Residual Income (RI) Method
4. Economic Value Added (EVA)

Divisional Income

Divisional income is a measure used to assess the performance of a division, similar to how corporate net income is employed to evaluate the overall performance of a company. Similar to related-party transactions in the context of financial accounting, the calculation of divisional income must consider transactions that take place both between divisions and between the division and corporate headquarters. One type of intra-company transaction involves the transfer of goods between divisions. These transfers represent revenue for the selling division and inventory costs for the buying division.

Another type of transaction involves receiving services from corporate headquarters or other responsibility centres within the company. Examples of such services include human resources, risk management, legal assistance and computer support. It’s common for companies to apply charges to the divisions that employ these services. The term refers to the controllable profit, which is calculated by subtracting the depreciation on divisional assets and other non-controllable divisional overheads from the overall profit. It follows that a number of the costs which are identifiable with the division are not controllable by the division.

Divisional income, due to its failure to consider division size, is inadequate for comparing performance among divisions of varying sizes. Divisional income is most meaningful as a performance measure when compared to the corresponding division’s income in previous periods or its budgeted income. 

Return on Investment (ROI)

Companies often refer to return on investment as their return on total assets. It evaluates the overall profitability of an investment by expressing it as a percentage of the initial investment amount.

Return on investment measures a company’s profitability and the effectiveness of its management in generating profits from the funds entrusted by investors.

Divisional income, due to its failure to consider division size, is inadequate for comparing performance among divisions of varying sizes. We can break down ROI into the following two components:

$\text{ROI=}\frac{\text{Divisional Income }}{\text{Divisional}\text{Investment}}=\frac{\text{Divisional Income }}{\text{Divisional} Revenue}\times \frac{\text{Divisional} Revenue}{\text{Divisional Investment}}$

OR

$\text{ROI=}\frac{\text{Proft} before tax}{\text{Capital} employed or investment}\times 100$

The initial term on the right-hand side is termed the return on sales (ROS), or the operating profit percentage. This ratio measures the amount of each dollar of revenue that contributes to the net income. ROS is often an important measure of the efficiency of the division, and the divisional manager’s ability to contain operating expenses.

The second term on the right-hand side is the asset turnover ratio or the investment turnover ratio. This ratio measures how effectively management uses the assets of the division to generate revenue. Interestingly, this ratio seems to hover around one for many companies in a wide range of industries, particularly in the economy’s manufacturing sector.

Breaking ROI into these two components often provides more useful information than solely examining ROI. It is an example of the type of financial ratio analysis that stock analysts conduct in evaluating the overall performance of a company. In this context, two common specifications for the denominator in the ROI calculation are assets and equity. We use the terms return on assets (ROA) and return on equity (ROE) to represent the resulting ratios.

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Importance of Return on Investment

The return on investment is a very important concept in the field of operational management and financial management. Its managerial uses include the following:

1) It is a measure of the overall profitability of an enterprise.

2) This tool enables the measurement and comparison of performance among various divisions within an enterprise.

3) This tool enables comparing performance among various enterprises within the same industry.

4) It offers a means to evaluate investment decisions, particularly in the context of capital budgeting or capital expenditure. The investment decision is a decision to invest in long-term assets. Other things remain the same, the projects yielding a higher rate of return on investment may be selected.

5) This method can aid in the planning of an optimal capital structure. A capital structure decision is a decision to decide upon the proportion of various sources of long-term funds, viz., long-term debts, preference shares, and equity funds (including retained earnings). A financial manager should not take a financial risk by employing funds carrying fixed financial charges if he is not in a position to generate a rate of return on investment (ROI) greater than the rate of fixed financial charges.

6) It can be used for determining the price of a product or a contract. The price of a product/contract should be fixed in such a way that a reasonable rate of return on investment is obtained after recovering the operating cost of that product/contract.

Disadvantages/Limitations of Return on Investment

ROI is one of the very important measures used to evaluate the overall financial performance of a company. However, it suffers from certain important limitations. These limitations are as follows:

1) Manipulation Possible

ROI is based on earnings and investments. Both these figures can be manipulated by management by adopting varying accounting policies regarding depreciation, inventory valuation, treatment of provisions, etc. The resolution regarding the majority of these matters is arbitrary and subject to the whims of the management.

2) Different Bases for the Computation of Profit and Investments

There are various methods for calculating both profit and investment each based on different factors. For example, fixed assets can be evaluated at gross or net values, while earnings can be considered before or after tax.

3) Emphasis on Short-Term Profits

ROI emphasizes the generation of short-term profits. The firm may achieve this objective by cutting down costs such as those on research and development or sales promotion. Cutting down on such costs without any justification may adversely affect the profitability of the firm in the long run, though ROI may indicate better performance in the short run.

4) Poor Measure

ROI is a poor measure of a firm’s performance since it is also affected by many extraneous and non-controllable factors. Often the present return is the result of the wisdom or folly of the past management. Thus, the present management cannot take credit or be held responsible for the doings of their predecessors.

5) Undue Significance to Capital Resources

ROI gives undue significance to capital resources whereas profits may be the result of contributions of various other inputs, particularly human resources. However, their role is not visible in the computation of ROI.

6) Damage Initiative

ROI, when used as a measure for the evaluation of the performance of managers, may ruin their initiative. Managers who are satisfied with the present ROI tend to become conservative and may not take any initiative to expand due to the fear of a decrease in the ROI. This would result in non-exploitation of the available opportunities and resources.

7) Chance Factor

Sometimes high or low profits can be attributed to chance. ROI in such cases, for judging the financial performance will be more or less irrelevant.

On account of the above limitations, it can be said the ROI is not an adequate measure for judging the financial performance of a business undertaking. Often it may create more problems than it may solve The will prove to be a good yardstick for measuring a fem’s performance if it is based on file ever a period instead of on figures for one or two years. Moreover, it will give better results if the firm has an effective system of budgetary control.

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