CHAPTER 4:

DIVISIONAL PERFORMANCE
Decentralization and
responsibility accounting
• Decentralization
• Structuring of the organisation into units, such as divisions and
departments, each with specific operational and decision-
making responsibilities
• Responsibility accounting
• Assigning responsibility to managers to run particular units of
the organisation
• Helps to reinforce the advantages of decentralisation
• Goal congruence helps ensure that decentralised organisations
are effective
• Consistency between managers’ personal goals and the goals
of the organisation
 Delegation of Decision Making
(Decentralization)

Top Decision Making

is pushed down.
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Decentralization often occurs as organizations continue to grow.

As organizations grow, decision-making must be pushed down to lower level
Managers. Organizations often decentralize into subunits to take advantage
of the specialized skills and talents of their sub-managers.
Decentralization
Advantages
Uses specialized
Allows organization knowledge and
to respond more skills of managers.
quickly to events.

Frees top management

Decentralization from day-to-day

operating activities.

Some of the advantages of pushing decision-making down to lower

level managers are: it allows managers to respond more quickly to
events, it uses the skills of those managers and it frees upper
management to focus on long-term planning and other strategic
goals.
Decentralization
• Benefits of decentralization
• Managers of units have more accurate and complete
local information about markets and operations to
enable them to manage their areas effectively
• Provides managerial training for future higher-level
managers
• May lead to increased motivation and job satisfaction
for unit managers
• Allows corporate managers more time for strategic
issues
• Delegation allows the organisation to react more quickly
to opportunities and problems as they arise
Decentralization (cont.)
• Costs of decentralization
• Managers may focus narrowly on their own unit’s goals
rather than on attaining the organisation’s overall goals
• Some tasks and services may be duplicated unnecessarily
• Goal congruence: a behavioural challenge
• Goal congruence may be difficult to achieve in a
decentralised organisation
• Performance measures and reward systems may provide
direction and incentives to achieve wider organisational
goals
 Decentralization
Challenge
Goal Congruence:
Managers of the subunits
make decisions that achieve
top-management goals.

Decentralization
The challenge, for a decentralized organization, is to induce managers to
behave in a manner that achieves organizational goals…. rather than
focusing on the goals of the subunit.
Responsibility centres
• A responsibility centre is a unit of an organisation where the
manager is held accountable for the unit’s activities and
performance
• Four (4) types of responsibility centres:
• Investment centre
• Profit centre
• Cost centre
• Revenue centre
Responsibility centres
(cont.)
The Purposes of Performance
measurement
• To communicate the strategy and plans of the business
and align employees’ goals with those of the
organisation
• Allow managers to track their own performance
against targets and take corrective action
• Evaluate subordinates’ performance, and provide
rewards
• Guide senior managers in developing future strategies
and operations
Measuring Performance
in Investment Centers
Investment Center
managers make
decisions that
affect both profit
and invested
capital.
Corporate Headquarters

Investment Return on investment,

Center residual income, or
Evaluation economic value added
Financial measures of
performance evaluation
• Below are the financial performance measures to
assess the performance of profit centres and
investment centres
• Return on investment (ROI)
• Residual income (RI)
• Economic value added (EVA)
RETURN ON INVESTMENT
(ROI)
• Used to measure the financial performance of an
investment centre

Net Profit
Return on investment 
Invested Capital
Return on investment (cont.)
profit
ROI 
invested capital
profit sales revenue
 
sales revenue invested capital
 return on sales  investment turnover

Invested capital
The assets that the investment centre has available to
generate profits
Return on sales/sales margin
The percentage of each sales dollar that remains as profit
after all the expenses are covered
Investment turnover 13-
The number of sales dollars generated by every dollar of 14
invested capital
Issue (1):
Measuring Investment
Capital
Three issues must be considered before we can properly measure
the investment capital:
 What assets should be included?
• Total assets.
• Total productive assets.
• Total assets less current liabilities.
• Average year end balances

In general, only the assets controllable by the manager’s

should be measured and evaluated.
Issue (2):
Measuring net profit
• Profit margin controllable by investment centre manager
• Suitable when the focus is to assess the performance of
the manager
• Encourages managers to focus on profit that they can
control
• Motivational impact

• Profit margin attributable to investment centre

• Suitable when the focus is to assess the performance of
the investment centre
Return on investment (cont)
• Improving ROI
• Increase return on sales
• By increasing the selling price or sales
revenue, or decreasing expenses (to increase
the net profit)
• Increase investment turnover
• By increasing sales revenue or reducing
invested capital
• Actions that are taken with the sole purpose of
making these ratios more favourable in the
short term may have adverse effects on
performance in future years
The Advantages Of ROI
• Widely used in practice to measure the performance
of units and managers
• Encourages managers to focus on both profits, and
the assets required to generate those profits
• Promotes an understanding of the relationship
between revenues, costs and assets
• Can be used to evaluate the relative performance of
investment centres, even when those business units
are of different sizes
The limitations of ROI
• It may encourage managers to focus on
improving short-term financial performance,
which may sometimes reduce long-term
financial performance
• May encourage managers to defer asset
replacement, to maintain a high ROI
• Discourages managers from investing in
projects which are acceptable from the
organisation’s point of view, but which
decrease the investment centre’s ROI
Minimising the behavioural
problems of ROI
• Use ROI as one of several performance measures
that focus on both short-term and long-term
performance
• Consider alternative ways of measuring invested
capital to minimise dysfunctional decisions
• Use alternative financial measures, such as residual
income or economic value added
RESIDUAL INCOME (RI)
• Residual income (RI)
= profit – (invested capital × imputed interest rate)
• Imputed interest charge
• Based on the required rate of return that the firm
expects of its investments, which is based on the
organisation’s cost of capital
• Weighted average cost of capital (WACC) is the
weighted average of the cost of funds from all
sources of borrowings and equity
The Advantages Of Residual
Income
• Is more flexible as the cost of capital applied to
investments can vary with different risk expectation.
• Using RI, investments earning more than the cost of
capital are accepted whilst those earning below the
cost of capital are eliminated.
• RI overcomes the dysfunctional aspect of ROI and
seeks to motivate managers to invest where the
expected returns exceed the expected cost of capital
• Encourages investment in projects which yield a
positive residual income to the organisation
• RI is an absolute measure
Disadvantages Of Residual
Income
• Cannot be used to assess the relative
performance of businesses that are of different
sizes
• Formula is biased in favour of larger businesses
• RI is an absolute measure and this makes inter-
company comparison difficult
• It does not relate the size of a centre’s income to
the size of the investment
ECONOMIC VALUE ADDED (EVA)
• One of the measurement of shareholder value
• Measure of the value created over a single
accounting period
• The spread between the return generated by
the business activities and the cost of capital
• EVA is an absolute measure and the calculation
is similar to residual income
 Comparing RI & EVA
• Formula for EVA resembles that of RI.

• However, it differs in several ways:

1) Definition of NOPAT is not necessarily the same as the

accounting measure of profit used in the RI formula.
Adjustments may need to be made to convert accrual
accounting data to cash-based figures & to eliminate the effects
of gearing.
2) WACC is used in the calculation of EVA, whereas in RI this is not
always the case.
3) In EVA formula, capital employed is often calculated as the
company’s total assets, less non-interest-bearing current
liabilities. In the RI formula, as in ROI, invested capital can be
defined in a variety of ways.
Economic Value Added
(Cont)
• To improve EVA
• Improve profitability without employing
additional capital
• Borrow additional funds when the profits
earned are more than the cost of
borrowing
• Pay off debt by selling assets
Economic Value Added
(Cont)
Advantages of EVA:
•Maximization of EVA will create real wealth
for shareholders
•An absolute measure which is easily
understood

Limitations of EVA:
•It is a single period measure of performance
or short term measure performance.
•EVA adjustments can be large and
problematic
•Does not take future-oriented perspective.