Essex Engineering
Essex is an industrial company with three divisions. Both the Midland Division and the North
Division are long established. Senior managers are concerned that these divisions have a high
percentage of products that are near the end of their product life-cycle. Forecast sales increases
over the next 5 years is expected to be in the region of 4-5% per annum.
The East Division was acquired in 1999 and senior managers are optimistic that this division has
very good growth potential. Most of the senior managers at this division have experience of
working at the other divisions.
Since 2009 the head office has ranked all divisions according to return on investment (ROI) and
residual income (RI). All managers believe that the rankings are important for future
promotions and career development.
A small number of other performance measures are also used by managers. These include
1.
Non-productive time: Non-productive direct labour hours (percentage of total hours paid).
Non-productive time includes time wasted as a result of production delays or material
shortages.
2.
Customers: Customer complaints (percentage of total number of customers)
3.
Lead time: Time from order to delivery
These performance measures were agreed by all managers in 2009. At the time it was thought
that managers should focus on only a small number of measures.
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2012
The managers at the divisions provided the following information for the head office.
Selected data from the budgeted Management Accounts to 31 December 2012
Midland
Division
£
Northern
Division
£
East
Division
Sales
Cost data
Controllable cost of goods sold
Non -controllable cost of goods sold
1,580,000 1,560,000 1,112,000
Controllable Selling general & Administrative overheads
Non-controllable Selling general & Administrative overheads
Total costs
370,000
400,000
370,000
250,000
250,000
162,000
1,386,000 1,385,000 1,012,000
Capital employed
Total investment
Controllable investment
1,400,000 1,440,000
1,200,000 1,111,000
650,000
116,000
Sales growth 2013
Sales growth 2014
620,000
115,000
380,000
100,000
850,000
800,000
4.80%
5.20%
28.00%
4.30%
5.10%
37.00%
1,580,000 1,560,000 1,112,000
Other measures
Non-productive time: Non-productive direct
labour hours (percentage of
total
hours paid).
Customer complaints (percentage of total
number of customers)
Lead time: Time from order to delivery
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2011
Midland
Division
4%
Northern
Division
4%
East
Division
6%
2012
2011
4.1%
1%
3.8%
1.2%
7.5%
5%
2012
2011
1.1%
10 days
1.1%
9 days
6%
15 days
2012
11 days
9 days
18 days
2
The head office has estimated that the group cost of capital is 10%
Ranking divisions in 2010
In 2010 the data on controllable and non-controllable costs and investments will be used to
rank divisions.
Question 1
Based on the data provided comment on the relative financial performance of the two divisions
and discuss how the ranking of the divisions changes if controllable and non-controllable costs
and capital employed are analysed.
Question 2
Evaluate the choice of performance measures for the 3 divisions
Question 3
Identify and evaluate the difficulties faced by managers when measuring capital employed for a
division.
Question 4
Discuss how using ROI can result in managers making poor investment decisions.
Question 5
Discuss the particular problems multinational companies have when evaluating the
performance of divisions.
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Solutions
Question 1
Answers
(a)
See spreadsheet
Midland
Division
Northern
Division
East
Division
1,580,00
0
650,000
930,000
116,000
814,000
370,000
1,560,00
0
620,000
940,000
115,000
825,000
400,000
1,112,00
0
380,000
732,000
100,000
632,000
370,000
250,000
194,000
560,000
250,000
175,000
540,000
162,000
100,000
362,000
1,385,00
0
1,020,00
0
365,000
1,012,00
0
Controllable costs
Non-controllable costs
1,386,00
0
1,020,00
0
366,000
Total investment
Controllable investment
1400000
1200000
1440000
1111000
850000
800000
Interest Charge (1)
Interest Charge (2)
Residual Income
Net Residual Income
Controllable RI
140,000
120,000
144,000
111,100
85,000
80,000
54,000
440,000
31,000
428,900
15,000
282,000
Sales
Controllable cost of goods sold
Contr. Gross profit
Non -controllable cost of goods sold
Gross profit
Controllable Selling general & Administrative overheads
Non-controllable Selling general & Administrative
overheads
Profit before tax
Controllable profit
Total costs
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750,000
262,000
4
ROI
Return on sales
Cost ratios
% controllable costs
Cost/sales
% controllable / sales
% non-controllable / sales
PBT / sales
Total
Controllable profit/sales
Controllable profit/ controllable capital employed
13.86%
12.28%
12.15%
11.22%
11.76%
8.99%
73.59%
73.65%
74.11%
64.56%
23.16%
12.28%
100.00%
35.44%
46.67%
65.38%
23.40%
11.22%
100.00%
34.62%
48.60%
67.45%
23.56%
8.99%
100.00%
32.55%
45.25%
Question 2
Evaluate the choice of performance measures for the 3 divisions
There must be a link between strategy and performance measures
Very unlikely that all divisions have the same strategy and measures
Also measures should change over time as strategy changes
Would prefer to see some cash flow measures - very important with worry of recession
Other measures that are important
Market share
More quality measures
Details of new product development
Question 3
(b)
What assets are included - how are they valued
What assets are not controllable
What assets are idle
Should liabilities be included or excluded
Gross book value or net book value or market value
Cost of getting information for market values
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Question 4
(c)
Behavioural problems
Examples of division with high ROI rejects good investment because ROI not
quite as good. Lowers overall ROI
Company with low ROI accepts investment which improves overall ROI but gives
return below cost of capital.
Question 5
(d)
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Currency translation – manager uses local currency but head office wants results
in home currency.
Changes is exchange rate can make manager look good or bad.
Problems of criticising manager for decline in exchange rate
Cultural and language barriers – limits to number of foreign managers!
Income taxes
Complicated reporting requirements
Volume of reports
Relative inflation
Legal differences can complicate evaluation
Import duties / tariffs
Management charges
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