© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 13
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CHAPTER 13
Performance Evaluation
of
Business Units
© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 13
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Learning Objectives

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

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How has the change to multidivisional organizations
impacted the way performance is evaluated within
organizations?
How can return on investment, residual income, and
economic value added be used to assess the performance
of company divisions?
Should corporate-level costs be included in the evaluation
of a business unit’s performance?
Why is it important to use more than just financial
measures of performance?
How can transfer pricing be used to help motivate
managers of divisionalized organizations to work costeffectively and competitively?
© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 13
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Structure of Business Organizations
Three types of Organizations
1. Private sector
 Businesses
whose prime goal is profit.
2. Public sector
 Government
funded and provides services for
the public
3. Not-for-profit sector
 Provides
a range of charitable or social
services
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Structure of Business Organizations
Functional Organization Chart
Divisional Organization Chart
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Responsibility Centres

Cost centre

No income generation responsibility
 Managed by ability to operate within cost budget

Profit centre
Responsible for ‘bottom line’ profits
 Evaluated on their performance compared to budget in
achieving or exceeding their profit target


Investment centre
 Have profit responsibility
 Evaluated based on a measure of the return on
investment made by the investment centre
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The Decentralized Organization and
Divisional Performance Measurement

Decentralization


Devolution of authority to make decisions
Divisionalization

Include both financial and non-financial performance
measures
 Divisional performance can be assessed through
budgets and performance against budgets
 Can also be assessed in terms of their ability to
manage and earn income relative to their strategic
investments
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Methods of Divisional
Performance Measurement
 Return
on investment (ROI)
 Residual income,
 Economic value added
© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 13
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Return on Investment (ROI)

Rate of return achieved on the capital
employed
ROI =
Operating profit
Total assets
Division A
Division B
Total Assets
$1,000,000
$2,000,000
Operating profit
$200,000
$300,000
20%
15%
Return on investment
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Example
2 Divisions
Investment
Profit
Division A
Division B
$4,000,000
$1,000,000
$20,000,000
$2,000,000
Absolute profit is higher
$1,000,000 is available for investment


2 competing projects
Cost of capital 15%
Anticipated profit
Profit
Division A
Division B
$200,000
$130,000
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Example - ROI
Division A
$4,000,000
$1,000,000
25%
Division B
$20,000,000
$2,000,000
10%
Additional investment
$1,000,000
Profit
$200,000
ROI on additional investment 20%
$ 1,000,000
$130,000
13%
Total investment
Profit
ROI
$21,000,000
$2,130,000
10.1%
Original Investment
Profit
ROI
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$5,000,000
$1.200,000
24%
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Example - ROI



Division A may not want its project to be approved as its
overall ROI will fall from 25% to 24%
Division B may want its project to be approved as its
overall ROI will increase from 10% to 10.1%
Corporate view is to prefer Division A investment as it
earns a higher ROI
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Residual Income (RI)
Profit remaining after deducting a portion of the capital
invested that represents the cost of capital from the
investment in the division
Residual income = Operating profit before tax - Capital charge

Division A
Division B
Capital invested
$1,000,000
$2,000,000
Operating profit
$200,000
$300,000
Less cost of capital at 17.5%
$175,000
$350,000
Residual income
$25,000
-$50,000
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Example – Residual Income
Division A
Division B
Original Investment
Profit
Cost of capital 15%
Residual income
$4,000,000
$1,000,000
$600,000
$400,000
$20,000,000
$2,000,000
$3,000,000
-$1,000,000
Additional investment
Profit
Cost of capital 15%
Residual income
$1,000,000
$200,000
$150,000
$50,000
$ 1,000,000
$130,000
$150,000
-$20,000
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Example – Residual Income

Under the residual income method,
Division A’s project would be approved as
it contributes to shareholder value,
whereas Division B’s project erodes
shareholder value
 Compare
the cost of capital of 15% to Division
B’s ROI (13% on new investment)
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Comparison of Techniques


Residual income is considered a stronger
measure than ROI because managers do not
feel constrained to meet a percentage target
Managers will make investments that have a
return in excess of a firm’s cost of capital,
whereas if they used only ROI as a basis for
evaluation, they might reject an investment if it
lowers the division’s overall ROI
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Economic Value Added

It deducts a percentage of the invested
capital from income to determine the true
earnings of a division
 It
is calculated using after-tax earnings
 It deducts the current liabilities from total
assets when determining the total invested
capital for the division
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Economic Value Added
Where
d is the cost of debt for the firm
e is the cost of equity for the firm
MVd is the market value of the firm’s debt
MVe is the market value of the firm’s equity
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Example
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Long-term debt market value = $12 million
Equity market value = $15 million
Cost of debit = 10%
Cost of equity = 15%.
Total assets = $10,500,000
After-tax profit = $1,525,000
Current liabilities end of period = $500,000
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Example
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Controllability



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
Allocating corporate charges to a division may be
necessary for financial reporting but is not always
desirable for performance evaluation purposes
Performance evaluation of managers can be carried out
based only on the controllable profit.

The controllable profit is the profit after deducting expenses that
can be controlled by the divisional manager, but it ignores those
expenses that are outside the divisional manager’s control
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Controllability
Sales
Less
1,000,000
Variable cost of goods sold
200,000
Other variable expenses
100,000
Contribution margin
Less
Controllable divisional overhead
300,000
700,000
250,000
Controllable profit
450,000
Less
175,000
Non-controllable overhead
Operating Profit
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Manager
accountable
for
Divisional
performance
275,000
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Non-Financial Performance Evaluation
Balanced Scorecard
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Transfer Pricing


Intention of transfer pricing is to create an environment
where managers are encouraged act competitively by
controlling costs and managing capacity efficiently
By using transfer prices between divisions, managers of
the supplying division are encouraged to make a profit
and, thus, to work efficiently and cost-effectively
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Transfer Pricing

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Transfer prices between divisions can be
established using several methods
Market transfer price
Marginal cost-based transfer price .
Full-cost transfer price.
Cost-plus transfer price
Negotiated transfer price
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Transfer Pricing Example
Division A produces 10,000 units at a cost of $100,000, with additional
production costs at $5 per unit
Division A sells its output to Division B at $13.
Division B carries out further processing which costs $300,000 with
additional costs of $13 per unit for units over 10,000.
Selling Price depends on quantity:
10,000 units $50/unit
12,000 units $46/unit
15,000 units $39/unit
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Transfer Pricing Example
Divisional
Financial
Results
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Transfer Pricing Example
Number of Units
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Conclusions
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Responsibility centres
 Cost, profit & investment centres
Divisional performance measurement
 Return on Investment, Residual Income,
Economic Value Added
Controllability
Non-Financial Performance Evaluation
Transfer pricing
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