Professional Scheme
Relevant to Paper 1.2

This article considers organisational structures and measures of divisional performance. Candidates need to develop competence in this vital area of financial management so they can advise senior management on an analysis of divisional performance measurement.

Major businesses usually require some sort of divisional structure. If it is to be made to work, each will have its own performance criteria. To the accountant, therefore, is bequeathed the problem of measuring how well or badly each division has been at meeting these criteria. A number of bases can be used, including profit margin comparisons, return on capital or economic value added. Whichever is chosen, it is essential that costs, revenue and asset valuations are adjusted so that ‘like with like’ comparisons are made. Questions of asset and cost allocation, valuation and apportionment all arise.

There are numerous examples of divisionalised structures. Many corporate structures comprise divisions with clear product remit. Such divisions often have their own management boards, financial targets and strategic plans. Often at the centre is group management responsible for strategic and financial control and ensures that management resource is optimised, best practice is adopted and synergies are realised between operating divisions.

Croda International for example is divided into three major business sectors: Cosmetic and Toiletries, Coatings and Chemicals. Each business sector sub-divides to divisions. The surface coatings sector comprises Industrial Paints, Powder Coatings, Printing Inks and Graphic Supplies.

In a previous financial report the chairman was quoted as “the company will maintain a prudent financial approach with a decentralised management judged, and rewarded by performance. Each division is expected to produce a satisfactory return on capital employed, be capable of showing consistent and long-term growth and achieve a significant position in its particular markets”.

Its overall aim “is to achieve long-term growth in earnings per share, by continuing to build a broadly based speciality chemical group with operations in main market areas of the world”.
It has been said that divisionalisation and decentralisation are sometimes regarded as synonymous but that in fact divisionalisation adds a new dimension by introducing performance responsibility to divisional management.

Fulfilment of that responsibility can only be encouraged, rewarded and tempered if performance is measured and monitored on a sound, accepted and comparable basis.

‘Responsibility centres’ provide the basis for one such approach. A responsibility centre has been defined by the Chartered Institute of Management Accountants as ‘a segment of the organisation where an individual manager is held responsible for the segment’s performance’.

There are three types of ‘responsibility centre’ – expense centres, profit centres, and investment centres:

• An expense centre is ‘a location, function or items or equipment in respect of which controls may be ascertained and related to cost units for control purposes’
• A profit centre is ‘a segment of the business entity by which both revenues are received and expenditures are caused or controlled. Such revenues and expenditure being used to evaluate segmental performance’.
• An investment centre is ‘a profit centre in which inputs are measured in terms of expenses and outputs are measured in terms of revenues, and in which assets employed are also measured, the excess of revenues over expenditure then being employed’.

Together they form the basis for ‘responsibility accounting’, a system of accounting, ‘that segregates revenues and costs into areas of personal responsibility in order to assess performance attained by persons to whom authority has been assigned’.

Thus it can be applied at all levels, to group, division, sector, business or product. The important point is that performance reporting reflects managerial responsibility and appropriate adjustments are made for those items which fall outside that responsibility.

Profit responsibility performance can be reflected in figures relating profit to turnover. However, performance may be subject to the fairness of apportioned costs and transfer prices.

Investment responsibility performance can be judged on the basis of return on investment or residual income (excess earnings over the cost of capital). In each case the assets/capital included should be that over which the responsible management has control. It is also clear that assets must be valued on a consistent basis so that like for like comparisons can be made between different investment responsibility centres.

Historical cost valuations should be converted to current valuations by using index numbers. Working capital should be included as part of the total assets/capital employed calculation with stocks valued on a similar basis between divisions.

When measuring the return, it is usual for the average capital employed/total asset figure for the period to be used (the calculation is earnings times 100, divided by investment [assets/capital employed]). This can be subdivided into profit margin (profit as a percentage of sales), and asset turnover (sales divided by investment [assets/capital employed]).

Cost of capital used in residual income calculations should be the cost of financing the business or division, of which the investment responsibility is being assessed. This may be an average cost based on group experience or an amalgam of different costs.

Residual income is a concept that has been used by accountants for four or more decades. Alfred Sloan, of General Motors Corporation, knew and used the principle in the 1920s.

More recently Stern Stewart New York Consultancy Group has ‘trade marked’ the term EVA (Economic Value Added) for what amounts to the same thing. EVA, according to the book The Quest for Value – the EVA Management Guide, is simply the net operating profit after tax less the cost of capital (the weighted average cost of debt and equity) used in the business.

Verity Perkins, a subsidiary of Lucas Verity, uses EVA to arrive at its investment decisions and performance measurement analysis and also to reward divisional managers and employees.

In a recent paper in Accountancy Age, Andrew Sawers stated that: ‘the formula works at any

level of business, from the consolidated group figures, to a subsidiary, to a business unit, to a product line’.

Measurement of divisional performance, therefore, calls for some form of responsibility accounting. It can be made in terms of earnings to sales, return on investment, residual income, or economic value added. But none is more fitting than residual income or its 1990s manifestation of economic value added.

The Example illustrates the performance measures mentioned earlier.

Example: Northcliffe Foods PLC
The animal feeds division of Northcliffe Foods Plc, results for year ended 31 December 2000 showed:

Profit for the year was £20.00m on a turnover of £40.00m giving a return to sales (profit margin) of 50%. However it must be noted that the division is only “management responsible” for 40% of its costs; 60% being transfers and apportioned costs.

Other divisional figures include:

The dividend to shareholders had been 15% and interest of 10% was paid on the debt.

Cost of capital is thus:

Return on Investment:
= Net Profit
Divisional Investment

= £20.00m x 100/1 = 25%
£80.00m

This is a very good return on capital, to put this in perspective the top five supermarkets over the past five years have averaged approximately 18.00%.

Asset Turnover:
Turnover
Divisional Investment

£40.00m = 0.5 times
£80.00m

The business is generating 0.5 times its capital base in the form of turnover.

Residual Income / EVA, Economic Value added:

The excess of earnings over the cost of capital.

Divisional Investment £80.00m
Cost of Capital ie:
13.75% x £80.00m = £11.00m
Divisional Earnings £20.00m
Residual Income £9.00m
Here we can see that the division has achieved earnings of £9.00m in excess of the cost of financing the division.

Managements performance would be measured using RI / EVA and often management and employees would be rewarded based on this performance measure.

Philip E Dunn, Esk Valley Business School