Question

Hello, I sent this case and an instructor solved it but I need more help to explain question one, how the rankings change based on the controllable and non controllable costs and employed capitals?

ternal Control : Performance Measures Essex Engineering Topic: Performance measures, Essex is an industrial company with three divisions. Both the Midland Division and the North Division are long established. Senior managers are concerned that these divisions have a high percentage of products that are near the end of their product life-cycle. Forecast sales increases over the next 5 years is expected to be in the region of 4-5% per annum. The East Division was acquired in 1999 and senior managers are optimistic that this division has very good growth potential. Most of the senior managers at this division have experience of working at the other divisions. Since 1999 the head office has ranked all divisions according to return on investment (ROI) and residual income (RI). All managers believe that the rankings are important for future promotions and career development. A small number of other performance measures are also used by managers. These include 1. Non-productive time: Non-productive direct labour hours (percentage of total hours paid). Non-productive time includes time wasted as a result of production delays or material shortages. 2. Customers: Customer complaints (percentage of total number of customers) 3. Lead time: Time from order to delivery These performance measures were agreed by all managers in 1999. At the time it was thought that managers should focus on only a small number of measures. 2002 The managers at the divisions provided the following information for the head office. Selected data from the budgeted Management Accounts to 31 December 2002 Midland Division Northern Division East Division $ $ Sales 1,580,000 1,560,000 1,112,000 Cost data Controllable cost of goods sold 650,000 620,000 380,000 Non -controllable cost of goods sold 116,000 115,000 100,000 Controllable Selling general & Administrative overheads 370,000 400,000 370,000 Non-controllable Selling general & Administrative overheads 250,000 250,000 162,000 Total costs 1,386,000 1,385,000 1,012,000 Capital employed Total investment 1,400,000 1,440,000 850,000 Controllable investment 1,200,000 1,111,000 800,000 Sales growth 2003 4.80% 5.20% 28.00% Sales growth 2004 4.30% 5.10% 37.00% 1,580,000 1,560,000 1,112,000 Other measures Midland Division Northern Division East Division Non-productive time: Non-productive direct labour hours (percentage of total hours paid). 2001 4% 4% 6% 2002 4.1% 3.8% 7.5% Customer complaints (percentage of total number of customers) 2001 1% 1.2% 5% 2002 1.1% 1.1% 6% Lead time: Time from order to delivery 2001 10 days 9 days 15 days 2002 11 days 9 days 18 days The head office has estimated that the group cost of capital is 10% Ranking divisions in 2000 In 2000 the data on controllable and non-controllable costs and investments will be used to rank divisions. Questions Question 1 Based on the data provided comment on the relative financial performance of the two divisions and discuss how the ranking of the divisions changes if controllable and non-controllable costs and capital employed are analysed. (provide the calculation to prove your standpoint) Question 2 Evaluate the choice of performance measures for the 3 divisions Question 3 Identify and evaluate the difficulties faced by managers when measuring capital employed for a division. Question 4 Discuss how using ROI can result in managers making poor investment decisions. ROI has some built in biases that can lead managers to make poor decisions. First, ROI requires that all costs and benefits be stated in dollars. Because it is usually easier to quantify costs than benefits, ROI measurements can be biased in a way that gives undue weight to costs. Second, ROI focuses on benefits that can be predicted. It also tends to emphasize short run benefits over long run benefits. This biases ROI calculations to weigh short term costs and benefits more heavily than long term costs and benefits. Question 5 Discuss the particular problems multinational companies have when evaluating the performance of divisions.

Answer 1

ANSWER 1

	Midland Division	Northern Division	East Division
SALES	158000	156000	111200
CONTROLLABLE COST OF GOODS SOLD	650000	620000	380000
CONTROLLABLE GROSS PROFIT	930000	940000	732000
NON-CONTROLLABLE COST OF GOOD SOLD	(116000)	(115000)	(100000)
GROSS PROFIT	814000	825000	632000
CONTROLLABLE ( SELLING & GENERAL OVERHEADS )	370000	400000	370000
NON-CONTROLLABLE ( SELLING & GENERAL OVERHEADS )	250000	250000	162000
PROFIT BEFORE TAX	194000	175000	100000
CONTROLLABLE PROFIT	560000	540000	362000
TOTAL COSTS `	138600	138500	101200
CONTROLLABLES COST	102000	102000	750000
NON-CONTROLLABLE COST	366000	365000	262000
TOTAL INVESTMENT `	1400000	1440000	850000
CONTROLLABLE INVESTMENT	1200000	1111000	800000
INTEREST CHARGE (i)	140000	144000	85000
INTEREST CHARGE (ii)	120000	111100	80000
RESIDUAL INCOME	NA	NA	NA
NET RESIDUAL INCOME	54000	31000	15000
CONTROLLABLE RESIDUAL INCOME	440000`	428900	282000

ANSWER 2

Performance measurement is a process by which an organization monitors important aspects of its programs, systems, and care processes.

The choice of performance measures for the 3 divisions that are evaluated as follows

- Its of very light possibility that all the 3 divisions must be following same strategical methods and measures for the conduction

- The measures adopted for ongoing running of the organisations and divisions should change over time in accordance with the change in measures adopted by the divisions and the organisation

- To establish the best outcome out of any divisions or organisation there should be a link and dependence between the strategy adopted and the performance measures followed


Measures that need to be accorded can be
- MARKET SHARE MEASURES
- QUALITY MEASURES
- CASH FLOW MEASURES ( CAN AVOID THE RISK OF RECESSION )
- UPDATES ON NEW PRODUCT DEVELOPMENT MEASURES

ANSWER 3

DIFFICULTIES FACED BY MANAGERS WHEN MEASURING CAPITAL EMPLOYED FOR A DIVISION

Two measures of divisional performance that are commonly used are:

1. Return on investment (ROI) % = controllable (traceable) profit/controllable (traceable) investment.
2. Residual income = controllable (traceable) profit – an imputed interest charge on controllable (traceable) investment.
   

While figuring out these calculations managers may face following difficulties


A) Which value should be taken into consideration Gross book value , net book value , or the market value available

B) Should the liabilities present or accounted be included while calculating capital employed or shall be excluded

C) What all assets that are present are non controllable assets

D) What all among the present asset list are to be included , and how are they to be valued by following which method

E) Cost incurred for getting the information about the present market values

F) What all of the assets present fall into the idle asset category

ANSWER 4

PROBLEMS ENCOUNTERED ARE

- A particular division with good ROI ( return on investment ) may or may not reject a proposal of investment because of the latter having a not good ROI ( return on investment ) can impact the overall ROI ( return on investment ) and hence lead to a downfall

- A particular division having low ROI ( return on investment ) may accept investments which can cause an increase the ROI ( return on investment ) but in the latter run proves out to be giving return even below cost of capital


ANSWER 5

PROBLEMS WHILE EVALUATING PERFORMANCE OF DIVISIONS

- Any legal differences present can complicate or hamper evaluation
- Currency differences a division uses local currency to evaluate but head office uses their home currency for evaluation
- Current changes in exchange rate can increase more difficulties
- Problem of relative Inflation
- Their can be problem of language barrier and cultural differences between managers of local division and head office.