Chapter 13
Strategic and Divisional
Performance Appraisal
Organisational structure
Performance measurement is directly linked to the
organisational structure of a business.
a distinction can be made between two categories of
organisational structure for performance appraisal:
Functional organisation structures.
Divisionalised organisation structures.
Functional organisation structures
A functional organisation structure is where a business is
divided into separate departments such as operations and
purchasing along with separate support departments such as
administration, accounting, marketing and sales. The managers
of each department are only responsible for their part in the
process of ensuring the provision and sale of a product or
service.
CEO
Women’s
Clothing
Men’s
Clothing
Children’s
Clothing
Other retail
departments…
Admin.
Stores
Other
functions…
Divisionalised organisation
structures
A divisionalised or decentralised organisation structure occurs
where the organisation is broken into divisions in accordance
with the products or services offered. Each divisional manager
is responsible for all the operations relating to their particular
product or service. Thus the autonomy experienced at CEO
level in a functional organisation is similar to that experienced
by a divisional head in a decentralised organisation structure.
CEO
Dublin Division
Cork Division
Limerick Division Other locations…
Women’s
Clothing
Women’s
Clothing
Men’s
Clothing
Children’s
Clothing
Other retail
departments
Women’s
Clothing
Men’s
Clothing
Children’s
Clothing
Other retail
departments
Admin.
Stores
Men’s
Clothing
Children’s
Clothing
Other retail
departments
Admin.
Stores
Other
functions…
Admin.
Other
functions…
Stores
Other
functions…
Performance measurement in a
divisionalised setting
These performance measurement systems depend on the
degree of decentralisation involved. There are four recognised
levels of decentralisation as follows:
Cost centres.
Revenue centres.
Profit centres.
Investment centres.
CEO
(Investment Centre)
Bowling
Snooker
Activity Area
Administration
Other areas…
(Revenue centre)
(Revenue centre)
(Revenue centre)
(Cost centre)
(Cost centre)
CEO
(Investment Centre)
Dublin City Division
Dublin North Division
Dublin South Division
(Profit centre)
(Profit centre)
(Profit centre)
Bowling
Snooker
(Revenue centre)
(Revenue centre)
Bowling
Snooker
(Revenue centre)
(Revenue centre)
Bowling
Snooker
(Revenue centre)
(Revenue centre)
Adventure Area Administration
(Revenue centre)
Adventure Area Administration
(Revenue centre)
Adventure Area Administration
(Revenue centre)
(Cost centre)
(Cost centre)
Other areas…
(Cost centre)
Other areas…
(Cost centre)
(Cost centre)
Other areas…
(Cost centre)
Cost centre
This is where the manager of such a centre or
division is responsible for the costs associated
with that centre and hence the main focus is cost
minimisation. This level of decentralisation
occurs normally in functional organisation types.
The key measures used in appraising
performance for a cost centre would be cost
variances from budget and individual cost items
(labour for example), as a percentage of total
costs.
Revenue centre
This is where the manager is totally concerned
with raising revenue with no responsibility for
costs. The key measures used in appraising
performance would be monitoring sales
variances from budget.
Profit centre
This is where the manager of such a centre or division
has responsibility for both revenue and costs for the
assets assigned to the division. Thus performance is
measured in terms of the difference between the
revenues and costs that relate to a profit centre. A profit
centre is like a separate company with its own profit and
loss account and the manager’s decisions relate to the
revenue and costs that make up the divisions profit
statement. The main performance measures focus on
cost and revenue variances to budget, as well as the
preparation of key profit ratios such as gross profit
percentage, operating profit percentage and expenses to
sales percentages.
Divisional profit statement
Investment centre
This is where the manager has responsibility for not
just the revenues and costs relating to the centre,
but also the assets that generate these costs and
revenues and the investment decisions relating to
disposal and acquisition of assets. For managers of
investment centres, the main performance measures
used will be based on return on investment and
breaking that down into its two component parts
namely operating profit margin and capital employed
turnover (asset turnover). Two measures of
divisional performance most commonly used are:
Return on investment (ROI).
Residual income.
Return on investment (ROI)
Return on investment (ROI) is very similar to
return on capital employed (ROCE) except the
focus is on controllable and traceable revenues,
expenses and assets.
Return on investment (ROI) = Divisional net profit x 100
Divisional net assets
Residual income
The residual income is profit earned less interest
on the capital that has been employed to
generate the profit.
Residual income = Divisional net
profit less an imputed interest charge
on divisional investment
Example 13.1: ROI and residual
income
Financial performance measures in
divisionalised organisations
A good performance measure
should
Provide incentive to the divisional manager to make
decisions which are in the best interests of the overall
company (goal congruence).
Only include factors for which the divisional manager
can be held accountable.
Recognise the long-term objectives as well as shortterm objectives of the organisation.
Example 13.2: ROI and residual
income in project appraisal
Example 13.2: ROI and residual
income in project appraisal
Example 13.2: ROI and residual
income in project appraisal
Example 13.2: ROI and residual
income in project appraisal
Advantages of return on
investment
It is a financial accounting measure that is
understandable to managers.
ROI can be further analysed into its component
parts of capital employed turnover (asset turnover)
and operating profit margin. These ratios can be
further divided into their component parts. This can
help management understand the drivers behind
ROI and hence work to improve the ROI.
ROI is a common measure and thus is ideal for
comparison across corporate divisions for
companies of similar size and in similar sectors.
Disadvantages of return on
investment
The level of investment or capital employed can be difficult to
measure and this can distort inter-firm comparisons. For
example, comparing ROI for hotels that periodically revalue
their property assets to those that don’t, can be misleading.
The companies with the revalued properties will have a higher
asset base and hence a lower return on investment. If assets
are valued at net book value, ROI and residual income figures
generally improve as assets get older. This can encourage
managers to retain outdated plant and machinery.
Different accounting policies will affect both profits and asset or
investment values. Thus inter-firm comparisons can be very
misleading if the companies involved do not have similar
accounting policies with regard to fixed assets, stocks and
certain intangible assets such as research and development.
The use of ROI can lead to dysfunctional decisions made by
managers as illustrated in example 13.2.
Advantages of residual income
Residual income is considered a better overall
performance measure as it is an absolute measure,
whereas return on investment is a relative measure and
hence suffers accordingly. As illustrated in example 13.2,
the use of ROI can lead to dysfunctional decisions.
Residual income, being an absolute measure, can lead
management to make decisions that maximise the
wealth of the business.
Disadvantages of residual income
It can be difficult to calculate a minimum required
return (cost of capital) for a business or division.
As with the return on investment, identifying the
appropriate value for investment or assets can be
difficult and subjective.
Residual income is not as well understood and
known by managers as return on investment.
Transfer pricing
Transfer pricing occurs where an organisation structures
itself into separate independent divisions. When
separate divisions within the organisation buy and sell to
and from one another, then transfer pricing occurs. The
transfer price is the cost of buying the product in the
buying division and is the sales revenue for the selling
division. The level of the transfer price will affect the
profitability of both divisions and thus has performance
appraisal implications. An agreed price must be found
that is fair to both divisions.
Transfer pricing
Set full cost price as the transfer price. This however is very
harsh on the selling division and undermines its profitability and
hence its performance appraisal.
Set cost plus a mark-up as the transfer price. This system
would help ensure the selling division has some element of
profit on the transaction.
Set market price as the transfer price. This is a feasible option
where prices would be set, based on listed prices of identical
products or services, or, on a price a competitor is quoting.
Set a transfer price based on negotiation between the
managers of the buying and selling divisions. This option often
has behavioural benefits, as managers develop an
understanding of each others problems.
Limitations of traditional financial
performance measures
1.
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3.
4.
5.
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7.
8.
Accounting measures are historical and backward looking in nature.
Accounting measures only present a limited picture of a business’s
performance.
Accounting indicators can focus too much on the short-term and can
give rise to short-term decisions that could have a harmful effect on
the business in the future.
Traditional financial measures tend to be quite inward looking and not
focused on external factors such as customers and competitors.
Financial analysts and capitalists are increasingly taking the view that
the intangible assets of a business are more likely to create future
value. However, these assets are so subjective to measure in financial
terms, that they are often ignored.
Accounting measures can ensure the focus is on cost rather than
value.
Single factor measures are capable of distortion by unscrupulous
managers.
They are of little use as a guide to action. If ROI or residual income
fall, they simply indicate that performance has decreased, without
indicating why.
Non-financial performance
indicators
In recent years, the trend in performance
measurement has been towards a broader view
of performance, covering both financial and nonfinancial indicators. By focusing solely on
financial performance measures, it is unlikely
that a full picture of divisional performance can
be obtained. .
Non-financial performance
indicators
Financial performance, focusing on profitability, liquidity,
efficiency, capital structure and market ratios.
Competitiveness, which measures market share, position and
sales growth
Resource utilisation, focusing on productivity, efficiency and
asset utilisation.
Quality of service, which focuses on several measures of service
quality including reliability, responsiveness, cleanliness, comfort,
friendliness, courtesy, communications and competence security.
Innovation, measuring the proportion of new to old products and
services, as well as new products and service sales levels.
Flexibility, measured in terms of volume as well as delivery
speed, and product or service specification flexibility.
Fitzgerald et al (1991)
The balanced scorecard
The balanced scorecard system was developed
from research undertaken by Professor Robert
Kaplan (Harvard Business School) and David
Norton (management consultant). The research
was based on the belief that managers need a
broad range of performance measures in order
to manage their businesses and that existing
financial performance measures were not
enough and actually limited a businesses ability
to create economic value.
The balanced scorecard
The balanced scorecard provides a framework
that translates the aims and objectives of a
business into a series of performance targets
that can be measured. Performance is
measured and the link to strategy ensures that
management can see if strategic objectives are
being achieved.
Balanced
scorecard
Innovation and
learning
perspective
How can we
continue to
improve
and create
value?
Financial
perspective
How do we look
to our
shareholders?
BALANCED
SCORECARD
Internal business
perspective
What must
we excel at?
Customer
perspective
How do
customers
see us?
The balanced scorecard
The financial perspective, focusing on traditional financial measures
such as sales growth, profit, return on capital and shareholders value.
The customer perspective, focusing on corporate customers service
objectives in terms of measures that correspond to customers priorities.
Performance measures for customers would include customer
satisfaction levels, customer retention and growth in customer
numbers.
The internal business processes perspective, focusing on what the
business must excel at and on the internal processes, decisions and
actions, if the business is to meet customer requirements.
Innovation and learning perspective, focusing on how a business can
continue to improve and create value. It measures how a business
seeks to learn, innovate and improve every aspect of the organisation.
The fact that it exists and is being measured, forces businesses to
become aware of and to monitor their propensity to innovate, retrain,
up-skill and improve performance in the face of competition.
The balanced scorecard
The term 'balanced' is used because managerial
performance is assessed under all four headings and
it implies that each quadrant is of equal importance
and deserves equal weighting.
This can help senior management evaluate whether
lower level managers have improved one area at the
expense of another.
The balanced scorecard will recognize the
improvement in financial performance but will also
reveal that this was achieved by sacrificing ‘on-time’
performance targets
Critical success factors (CSF) and
key performance indicators
When using the balanced scorecard, an
organisation has to decide which performance
measures to use under each heading.
Areas to measure should relate to an
organisation's critical success factors.
Critical success factors (CSF)
Critical success factors (CSFs) are performance
requirements which are fundamental to an
organisation's success (for example innovation
in a consumer electronics company) and can
usually be identified from an organisation's
mission statement, objectives and strategy.
Key performance indicators
Key performance indicators (KPIs) are measurements of
achievement of the chosen critical success factors. Key
performance indicators should be:
Specific: For example, measure profitability rather than 'financial
performance', a term which could mean different things to different
people.
Measurable: Key performance indicators must be capable of having
a measure placed upon them, for example, number of customer
complaints rather than the 'level of customer satisfaction'.
Relevant: Key performance indicators must relate to and measure
the achievement or non-achievement of a critical success factor.
Commonly Used Measures (KPI) in
Balanced Scorecard (UK)
Source: A Practical Guide to the Balanced Scorecard (CIMA)
Example 13.3: Balanced scorecard
Example 13.3: Balanced scorecard
The balanced
scorecard in
Hospitality
Louvieris et al
Advantages of the balanced
scorecard
It measures performance in a variety of ways, rather than
relying on one figure.
Managers are unlikely to be able to distort the performance
measure as bad performance is difficult to hide if multiple
performance measures are used.
It takes a long-term, strategic approach to business
performance.
Success in the four key areas should lead to the long-term
success of the organisation.
It is flexible, as what is measured can be changed over time to
reflect changing priorities.
'What gets measured gets done'. If managers know they are
being appraised on various aspects of performance, they will
pay attention to these areas, rather than simply paying 'lip
service' to them.
Disadvantages of the balanced
scorecard
Setting standards for each of the key performance
indicators can prove difficult where the organisation
has no previous experience of performance
measurement. Benchmarking with other
organisations is a possible solution to this problem.
Allowing for trade-offs between key performance
indicators can be problematic. How should an
organisation judge a manager who has improved in
every area apart from say, financial performance?
One solution to this problem is to require managers
to improve in all areas and not allow trade-offs
between the different measures.