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Divisional Performance

What is Divisionalisation?
Divisionalisation is the situation where managers of business areas are given a
degree of autonomy over decision making i.e. they are given the authority to make
decision without reference to senior management. In effect they are allowed to run
their part of the business almost as though it were their own company.
Advantages

Disadvantages

Specialism in

Coordination difficulties

product/country/customer

Requires transfer prices to be

Greater motivation for managers

established

Allows divisions to be profit Centres

Lack of goal congruence,

(motivating and promotes efficiency)

dysfunctional decision-making

Allows performances between

Difficulties in fair comparison of

divisions to be compared

divisions.

Clearer objectives for managers

Potential duplication of some services

(concentrate on one area of the


business only)
Usually accompanied by
decentralization, so potentially better
decisions.
Problems with divisionalisation:
Coordination difficulties
Requires transfer prices to be established
Lack of goal congruence/dysfunctional decision-making
Difficulties in fair comparison of divisions.
Potential duplication of some services
Divisional Performance Measures
1. Return on Investment (ROI)
ROI is defined as: Controllable division profit as a percentage of divisional
investment.
It is equivalent to ROCE hence very popular
ROI
= Controllable profits from operations X 100
Controllable capital employed
Decision rule:
ROI > cost of capital (accept the project/ division is performing
favourably)
Advantages
Disadvantages
Widely used its equivalent to
May lead to dysfunctional

ROCE
Able to compare divisions of
different sizes
It can be broken down into
secondary ratios
For more detailed analysis, profit
& asset
turnover

decision making
Increases with age of asset if
NBV are used
Different accounting policies can
confuse
comparisons

Example
Balaka plc has divisions throughout the Nyasa States. The Liwonde division is
currently making a profit of MK82, 000 p.a. on investment of MK500, 000. Balaka
has a target return of 15%. The manager of Liwonde is considering a new
investment which will require additional investment of MK100, 000 and will
generate additional profit of MK17, 000 each year/
(a) Calculate whether or not the new investment is attractive to the company as a
whole.
(b) Calculate the ROI of the division, with and without the new investment and
hence determine whether or not the manager would decide to accept the new
investment.
The circumstances are the same as in example 1, except that this time the manager
of the Liwonde division is considering an investment that has a cost of MK100, 000
and will give additional profit of MK16, 000 p.a.
(a) Calculate whether or not the new investment is attractive to the company as a
whole.
(b) Calculate the ROI of the division, with and without the new investment and
hence determine whether or not the manager would decide to accept the new
investment.
In this example the manager is not motivated to make a goal congruent decision.
For this reason, a better approach is to assess the managers performance on
Residual Income.
2. Residual Income (RI)
MK
RI = Controllable profit from operations
XXXXX
Less: Imputed interest (controllable capital employed X Cost of capital)
XXXXX
XXXXX
Note: used PBIT if profit from operations is not given
Advantages
Disadvantages
Reduces problems of ROI i.e.
Difficult to decide upon an
dysfunctional behavior and
appropriate cost of capital

holding onto old assets


Cost of financing a division is
brought home to division
managers
Different cost of capitals can be
applied to different divisions
based on their risk profile

It does not facilitate comparisons


btwn divisions since the RI is
driven by the size of the divisions
and their investment
Different accounting policies can
confuse comparisons same as
ROI
It does not always result in
decisions that are in the best
interests of the company

3. Economic Value Added (EVA)


EVA = Net operating profit after tax WACC x book value of capital
employed
The principle - business is only really creating value if its profit is in excess of the
required minimum rate of return that shareholders and debt holders could get by
investing in other securities of comparable risk.
The capital employed is the opening capital employed, adjusted for the items set
out below.
Calculations of Net Operating Profit after Tax (NOPAT)
MK
Add:
Accounting depreciation
XXXX
Increase in provisions
XXXX
Non-Cash expenses
XXXX
Advertising, R&D
XXXX
Employee training costs
XXXX
Operating lease payments
XXXX
Goodwill written off
XXXX
Deduct:
Economic depreciation
(XXXX)
Decrease in provision
(XXXX)
Amortisation of advertising, R&D, Employee training
(XXXX)

Depreciation of operating lease assets


(XXXX)
Tax charged plus tax relief on interest (Interest X tax rate)
(XXXX)
NOPAT
XXXX
Note: Goodwill written off is also add back to capital employed
WACC = (proportion of equity X cost of equity) X (proportion of debt X
post tax cost of debt)
Advantages
EVA consistent with NPV.
Maximization of EVA will create
real wealth for shareholders
Adjustments made avoids
distortion as a result of
accounting policies and should
result in goal congruence
Long-term value adding
expenditure are capitalised,
removing any incentive to shortterm view

Disadvantages
Numerous adjustments to profit
and capital employed figures
which can be cumbersome
Does not facilitate comparisons
btwn divisions since EVA is an
absolute measure (as is RI)
Many assumptions made when
calculating the WACC, making its
calculations difficult and
potentially inaccurate
Based on historical data whereas
shareholders are interested in
future performance

Example: EVA Calculations


Extracts from the accounts of Value Co are as follows:
Income Statements:
2014
2013
MKmillion
MKmillion
Revenue
608
520
Pre-tax accounting profit (note 1)
134
108
Taxation
(46)
(37)
Profit after tax
88
71
Dividends
(29)
(24)
Retained earnings
59
47

Balance Sheets:
2014
MK
Non-current assets
Net current assets
Financed by:
Shareholders funds
Medium and long-term bank loans

250
256
506
380
126
506

2013
MK
192
208
400
312
88
400

Note: After deduction of the economic depreciation of the companys non-current


assets.
This is also the depreciation used for tax purposes. Other information is as follows:
1. Capital employed at the end of 2012 amounted to MK350m.
2. Value Co had non-capitalized leases valued at MK16m in each of the years 2012
to 2014.
The leases are not subject to amortisation.
3. Value Cos pre-tax cost of debt was estimated to be 9% in 2013 and 10% in 2014.
4. Value Cos cost of equity was estimated to be 15% in 2013 and 17% in 2014.
5. The target capital structure is 70% equity and 30% debt.
6. The rate of taxation is 30% in both 2013 and 2014.
7. Economic depreciation amounted to MK64m in 2013 and MK72m in 2014. These
amounts
were equal to the depreciation used for tax purposes and the depreciation charged
in the income statements.
8. Interest payable amounted to MK6m in 2013 and MK8m in 2014.
9. Other non-cash expenses amounted to MK20m in 2013 and MK15m in 2014.
10. Research and development expenditure on a new project started in 2013 and
written off was MK10 million in 2013 and MK11 million in 2014
Required: Calculate the Economic Value Added in each of 2014 and 2013.

Potential problems of EVA


It is difficult to use EVA to compare firms or divisions because it is an absolute
measure and takes no account of the relative size of the business.
Because EVA is a year-to-year measure, it could be improved in the short
term but to the detriment of the business in the long term.
Economic depreciation is difficult to calculate and conflicts with generally
accepted accounting principles.
Other factors that could be important but are not included in the accounts are
ignored.

EVA is a short-term measure whereas performance measures should focus on


the longer- term forecasts. Ideally economic income would be used (by
discounting estimated future cash flows) but even ignoring the complexity of
this, the person responsible for estimating it would very often be the person
being measured, which could lead to bias.
EVA solves problems of profit-based measures as the primary measure of
their financial performance. Two problems relating to profit in this area are:
1. Profit ignores the cost of equity capital. Companies only generate wealth
when they generate a return in excess of the return required by providers of
capital both equity and debt. In financial statements, the calculation of
profit does take into account the cost of debt finance, but ignores the cost of
equity finance.
2. Profits calculated in accordance with accounting standards do not truly reflect
the wealth that has been created, and are subject to manipulation by