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Divisional Performance Measurement
3. Divisional Performance Measures
3.1 Introduction This chapter describes the different financial performance measures that are presented in management accounting literature to evaluate divisional performance and provides a summary of the empirical studies relating to the usage of these measures. It begins with a discussion of the theoretical distinction between the economic and managerial divisional performance measures. This is followed by a brief summary of the limitations of traditional divisional financial measures and a description of two major innovations in the 1990s that sought to overcome these limitations. 3.2 Distinguishing between divisional managerial and economic performance Traditionally, literature has advocated that divisional financial performance measurement should distinguish between the performance of divisional mangers and the economic performance of the divisional unit (Dearden, 1987; Drury, 2000, p. 796). To evaluate the economic performance of divisions, corporate management requires a periodic reporting system providing attention-directing information. Such attention-directing information highlights those divisions that require more detailed studies to examine their economic viability and ways of improving their future performance. If the purpose is to evaluate the performance of divisional managers, only those items that are controllable, or influenced by the divisional manager, should be included in the performance measure. The need to distinguish between divisional managerial and economic performance leads to three different profit measures – divisional controllable profit, divisional contribution to corporate sustaining costs and profits and divisional net income. Divisional controllable profit is advocated for evaluating divisional managerial performance because it includes only those revenues and expenses that are controllable or influenced by divisional managers. Thus, the impact of items such as foreign exchange rate fluctuations and the allocation of central administrative expenses may be excluded on the grounds that managers cannot influence them. However, such expenses may be relevant for evaluating a division’s economic performance.
Those non-controllable expenses that are estimated to be avoidable in the event of divisional divestment are deducted from controllable profit to derive the divisional contribution to corporate sustaining costs. Examples of such expenses include the allocation of those corporate joint resources shared by divisions that fluctuate according to the demand for them. Assuming that cause-and-effect allocations can be established that provide a reasonable approximation of the cost of joint resources consumed by a division, then the allocated cost can provide an approximation of avoidable costs. Thus, the divisional contribution to corporate sustaining costs and profits is appropriate for measuring divisional economic performance since – as its name implies – it aims to provide an approximation of a division’s contribution to corporate profits and unallocated corporate sustaining overheads. Divisional net income is an alternative measure for evaluating divisional economic performance. It includes the allocation of all costs. From a theoretical point of view, this measure is difficult to justify, since it includes arbitrary apportionments of those corporate sustaining costs that are likely to be unavoidable unless there is a dramatic change in the scale and scope of the activities of the whole group. The main justification for using this measure is that corporate management may wish to compare a division’s economic performance with that of comparable firms operating in the same industry. The divisional contribution to corporate sustaining costs and profits is likely to be unsuitable for this purpose. This is because divisional profits are likely to be overstated due to the fact that, if they were independent, they would have to incur some of the corporate sustaining costs. The apportioned corporate sustaining costs therefore represent an approximation of the costs that the division would have to incur if it traded as a separate company. Consequently, companies may prefer to use divisional net profit when comparing the performance of a division with similar companies. To compare the financial performance of different companies or divisions, a profitability measure is required that takes into account the differing levels of investment in assets. Return on investment (ROI) meets this need by acting as a common ratio denominator for comparing the percentage returns on investments of different sizes in dissimilar businesses, such as other divisions within the group and outside competitors. It has become established as the most widely used single summary measure of financial performance. According to Johnson and Kaplan (1987), it was developed by Du Point in the early 1900s and since then it has become widely used by ‘outsiders’ to evaluate company performance. Its major benefit is that it provides a useful overall approximation of the success of a firm’s past investment policy by providing a summary measure of the ex post return on capital invested. A further attraction of ROI is that it is a flexible measure. The numerator and denominator can include all – or just a subset – of the line items that appear on corporate financial statements. It can be adapted to measure managerial performance by expressing controllable profit as a percentage of controllable investment.