CIMA Review

Two types of divisional centre 1) Profit centres 2) Investments centres – has autonomy of freedom such as developing new product, new makets Six Benefits of divisionalisation 1) Better access to market information 2) Motivating middle/ junior managers 3) Developing managers through experience 4) Better use of specialised knowledge 5) Allow senior managers focus on strategic issues 6) Timely decision making Problem 1) Goal conflict between divisions 2) Avoidance of risky courses of action 3) Excessive management “Perks” 4) Inter- divisional competition 5) Costly duplication of facilities Divisional Income: Transfer of goods (revenue to selling division; cost of inventory to the buying division) Transfer of services (such services are human resources. Legal, risk management, and computer support) To evaluate divisional performance The need to distinguish profit measures between divisional managerial and economic performance Three different profit measures: 1) Divisional controllable profit 2) Divisional contribution to corporate sustaining costs and profits 3) Divisional net income 1) Divisional controllable profit Evaluate divisional managerial performance because it includes only those revenue and expenses that are expenses that are controllable or influence by divisional managers. Items which are non-controllable or the mangers cannot influence them are excluded, such as Foreign exchange rate flotation and the allocation of central administrative expenses. Problem: The non-controllable may be relevant for evaluating a division’s economic performance. 2) Divisional contribution to corporate sustaining costs. Divisional contribution to corporate sustaining costs= (Controllable profit) – (Non-controllable expense) It aims to provide an approximation of a division’s contribution to corporate profits and unallocated corporate sustaining overheads. 3) Divisional Net income An alternative measure for evaluating economic performance that includes allocation of all costs. It use to compare a division’s economic performance with that of comparable firms operating in the same industry ROI is more appropriate to use for evaluating the economic performance of a division than managerial performance. ROI = Divisional Profit/ Divisional Investment *100 or ROI = (Divisional Income/ Divisional Revenue) * (Divisional Revenue/ Divisional Investment) Return on sales or Operating profit asset turnover ratio or investment turnover ratio 1

ROS: is often an important measure of the efficiency of the division, and the divisional managers’ ability to contain operating expenses Asset turnover ratio: measures how effectively management uses the division’s asset to generate revenues. Assets can be valued at their 1) Gross book value (acquisition cost) 2) Net book value (acquisition cost – depreciation expense): sometimes discourage division manger replace old equipment. 3) Replacement cost or Net realizable value or Fair market value Weakness of ROI , The measure may encourage divisional managers to maximize the ratio, which can lead to suboptimal decision. Current ROI is 30%, cost of Capital is 15% the manager will reject ROI lower than 30% but higher than 15%. Using Residual income instead of ROI Residual income = Operating income – (investment Base * Required rate of return) Advantages: -It enables different risk- adjusted capital cost to be incorporated into the computation. -Goal congruence -It have the “minimum return” One type of residual income calculation is called EVA

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Limitations of Financial performance measures Short term measurement period, encourage managers to become short term oriented. e.g. (reject positive that have an initial adverse impact but high payoff in later periods). Lagging indicators Historical cost concept tend to poor estimates of economic performance In order to Improve the financial performance measures: EVA ( Economic value Added)

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EVA = conventional divisional profit+/- accounting adjustments – cost of capital charge on divisional assets. Closest to cash flow, less subject to the distortion and bias arising from accrual accounting Avoid the arbitrary distinction between investments in tangible and intangible Prevent the amortisation/ write of f of goodwill Bring off BS debt into the BS as is the case when assets are subject to leasing Correct for the bias associated with accounting depreciation In order to improve the non-financial performance measures: Balanced Scorecard Four perspectives: 1) Financial – how the shareholders view the firm ( Growth stage, sustain stage, or Harvest stage) 2) Internal processes – address the question of which processes are most critical for satisfying customer and shareholders 3) Customers – how the firm is view by customers ( Time, quality, performance and cost) 4) Learning and growth – how the firm must lean, improve and innovate in order to meet its objective. (Strategic Objectives; Measures; Targets; Initiatives) Other Note: Alternative measurement other than ROI and RI: NPV, particularly if the NPV evaluation is risk adjusted. Required rate of return 12%, calculated RI is 13%, it means $1 of extra RI per $100 if extra asset employed by the proposal. Weakness of NPV -> cannot measure results periodically.

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EVA =Net operating profit after tax – WACC * book value of capital employed Or = NOPAT – (cost of capital)*(invested capital) Advantages -As a performance metric, is the link with long-term wealth maximization and discount factor techniques. -It also linked to management compensation -The closest method to capture the true economic profit and directly link to the creation of shareholder wealth over time. - 1) Profits are shown in the way shareholders count them (consider cost of capital) - 2) Company decisions are aligned with shareholder wealth - 3) a financial measure is used that line managers understand - 4) The confusion of multiple goals is ended 1) Profits are shown in the way shareholders count them (capital charge) Profit is not equal to Value, cash saving in bank can create profit but the cash will not create any value By taking all capital costs into account, including cost of equity, EVA shows the amount of wealth a business has created 2) Company decisions are aligned with shareholder wealth The principle for mangers to make decision 1) maximise the wealth of shareholders; 2) value of a company depends on the extent to which investors expect future profits to exceed or fall short of the cost of capital 3) A financial measure is used that line managers understand Conceptually simple and easy to explain to non-financial managers. EVA can measures results periodically. EVA measures performance in ‘value’ 4) The confusion of multiple goals is ended Only focus on how to improve EVA- always in terms of the value added to shareholder investment Adjustment to net profit Add net capitalised intangibles Add goodwill written off and accounting depreciation Add increase in provisions such as those in respect of bad debt and differed tax Add back interest on debt capital Adjustment to capital employed Add net book value of intangible Add cumulative goodwill and accounting depreciation Add provision such as those in respect of bad debt and differed tax Add debt to net assets such that it forms part of capital employed

Note: EVA is similar to RI. EVA is market focus or Economic focus. Two reason why EVA better than ROI 1. Steering failure in ROI Increase in ROI is not necessarily good for shareholders i.e. maximizing ROI can not be set as a target. (Increase in ROI would be unambiguously good only in the companies where capital can be neither increased nor decreased -> [an error occurred while processing this directive] 2. EVA is more practical and understandable than ROI

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As an absolute and income statement -based measure EVA is quite easily explained to non-financial employees and furthermore the impacts of different day-to-day actions can be easily turned into EVA-figures since an additional $100 cost decreases EVA with $100. (ROI is neither easy to explain to employees nor can day-to-day actions easily be expressed in terms of ROI) This latter benefit if often totally forgotten in academic discussion since it can not, of course, be visible in desk studies or empirical studies which try to trace the correlation of EVA and share prices Equity investors should earn on their capital a return far over risk-free interest rate in order to induce and maintain capital in the company Therefore earnings should always be judged against the capital used to produce these earnings

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