Scribd
Upload
2K views5 pages

Divisional Performance Appraisal

Divisionalization breaks a company into profit-responsible divisions, each headed by a manager with authority over operations. Reasons for divisionalization include allowing more accurate performance measurement and providing training for top management. Measures of divisional profitability include ROI (return on investment), calculated as profit/investment, and RI (residual income), calculated as income - interest charge. Both have advantages like motivating optimal asset use, but also limitations like subjective judgments in calculations and potential distortions of resource allocation.

Uploaded by

Manu Verma
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
2K views5 pages

Divisional Performance Appraisal

Divisionalization breaks a company into profit-responsible divisions, each headed by a manager with authority over operations. Reasons for divisionalization include allowing more accurate performance measurement and providing training for top management. Measures of divisional profitability include ROI (return on investment), calculated as profit/investment, and RI (residual income), calculated as income - interest charge. Both have advantages like motivating optimal asset use, but also limitations like subjective judgments in calculations and potential distortions of resource allocation.

Uploaded by

Manu Verma
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
You are on page 1/ 5

June/July 2003 6b

What is divisionalisation and what are the reasons for divisionalisation?

Divisionalisation is defined as breaking down the company into units called


divisions headed by people fully responsible for the profitability of its operations,
including planning, financial and accounting activities. In divisionalisation, the
divisional head enjoys the authority to determine how the operations under his
control are to be carried out.

Reasons for divisionalisation

1. Entrusted with profit responsibility a manager makes rational trade-offs


between revenues and costs. Without decentralized profit responsibilities, it
becomes necessary to exercise control over his day to day decisions.
Divisional operations provide an excellent training ground for grooming top
management personnel.
2. When a manager is given operational autonomy his performance can be
measured more accurately.
3. Information about the profit performance of various divisions in relation to
the company as a whole is helpful in strategy formulation and resource
allocation.
4. It is believed that a higher level of performance is attained when greater
scope for initiative is provided to responsible individuals.
5. A divisional set up brings about a kind of decentralization which is pre-
eminently suited to a higher diversified firm, the various activities of which
may call for different types of organization structures.

Jan /Feb. 2004 7c

Discuss the nature, methodology, advantages, limitations of the following


measures of divisional profitability and performance

(i) ROI Method (ii) RI Method

Dec/Jan 2007

Explain the advantages and limitations of ROI and RI Method of measuring


divisional performance?
(i) Return on Investment(ROI) Method

The return on investment (ROI) is defined as ratio of profit to investment.

ROI=Profit/Investment

Measurement of profit:
3 important profit measures are considered for measuring divisional
profit.
1) Net profit(before or after tax).
2) Contribution margin
3)Controllable profit

Measurement of investment : Here we have to consider:-


1) Scope of divisional investments:- Making the appropriate choice
among divisional total assets, net assets, or fixed assets plus net
current assets to measure investments. Total divisional assets is the
most appropriate choice.
2) Valuation of fixed assets: Fixed assets can be valued on the basis of :-
i) Original Cost
ii) Net book value:- Net book value = Cost-Depreciation
iii)Appraised Value:- like replacement value or current market price.

3) Treatment Of shared or Corporate Assets: The shared assets used by

Divisions are grouped as follows:-


i)Fixed assets at Head office: There is no point in allocating centrally
held and centrally used assets.
ii)Shared Facilities:
a)Building:- investment in shared buildings allocated on the basis of
floor areas occupied by the divisions.
b)Services and Facilities:- investment in shared services and facilities
are allocated on the basis of proportionate usage by the divisions.
iii)Cash: Centrally managed cash is allocated on the basis of cash
expenses or sales.
iv) Receivables: Receivables are allocated on the basis of total sales,
proportion of credit sales and average collection period concerned with
the divisions.

Performance Assessment

The ROI of a division may be analyzed in terms of its profit margin and investment
turnover.

ROI = Profit Margin * Investment turnover

= (Profit/Sales)*(Sales/Investment)

The target ROI can achieved by any combination of investment turnover and
profit margin.

Advantages Of ROI Method

• ROI is widely accepted and understood,it is comprehensive measure of


business performance.

• ROI can be used for comparative analysis since it’s a ratio.

• ROI provides motivation for optimal asset utilization.

Disadvantages Of ROI Method

• Many subjective judgments are applied in computing divisional profit and


investment.

• The use of ROI may distort allocation of resources of the firm. Division may
choose the investment opportunity which benefits the division by but not
the one desirable from the company point of view.
• The methods employed in practice to calculate the investment base tend to
motivate managers to take decisions which may not be congruent with the
larger interests of the firm.

ii) Residual Income (RI) Method


RI is defines as income after deducting interest charge.

Residual income = Divisional income-Interest charge.

Here the aggregate divisional investment was multiplied by the average cost of
capital to get interest charge.

Where, Interest charge= (Investment in divisional assets)* (cost of capital)

For greater refinement, different interest rates may be applied to different


components of investments like fixed assets , inventories, receivables and cash .

Advantages Of RI Method

 Permits the use of different rate of return for different rates of return for
different types of assets. For example, the cost of long term funds may be
used for fixed assets while the cost of short-term borrowings may be used
for current assets. A higher rate of return may be applied to high-risk
investment and a lower rate of return may be applied to low-risk
investment.
 It encourages the divisional manager to undertake projects whenever the
rate of return exceeds cost of capital. In this way it overcomes a signal
shortcoming of ROI method, where the manager acts contrary to interest of
the firm.

Limitations of RI Method

 Like ROI method, the problems related measuring divisional income and
investment as present in measurement of RI as well.
 Defining rate of return associated with various investment components is
difficult.
 RI is absolute quantity so it cannot be used readily for inter-divisional or
inter-firm comparisons.
 ROI=(RI/I)+k; where I-=Investment; K= cost of capital
RI is readily transformed into ROI, both show different results and when
there is conflict often ROI is preferred, so RI is relatively neglected.

You might also like