Decentralisation is essentially the delegation of decision-making responsibility. All organisations decentralise to some degree; some do it more than others. Decentralisation is a necessary response to the increasing complexity of the environment that organisations face and the increasing size of most organisations. Nowadays it would be impossible for one person to make all the decisions involved in the operation of even a small company, hence senior managers delegate decision-making responsibility to subordinates. Show
One danger of decentralisation is that managers may use their decision-making freedom to make decisions that are not in the best interests of the overall company (so called dysfunctional decisions). To redress this problem, senior managers generally introduce systems of performance measurement to ensure – among other things – that decisions made by junior managers are in the best interests of the company as a whole. Table 1 below details different degrees of decentralisation and typical financial performance measures employed. TABLE 1
Profit centres and investment centres are often referred to as divisions. Divisionalisation refers to the delegation of profit-making responsibility. What makes a good performance measure?A good performance measure should:
Traditional performance indicatorsCost
centres Profit centres TABLE 2
The major issue with such statements is the difficulty in deciding what is controllable or traceable. When assessing the performance of a manager we should only consider costs and revenues under the control of that manager, and hence judge the manager on controllable profit. In assessing the success of the division, our focus should be on costs and revenues that are traceable to the division and hence judge the division on traceable profit. For example, depreciation on divisional machinery would not be included as a controllable cost in a profit centre. This is because the manager has no control over investment in fixed assets. It would, however, be included as a traceable fixed cost in assessing the performance of the division. Investment centres
Example 1 below demonstrates their calculation and some of the drawbacks of return on investment. Example 1:
Required:
Commentary: In simple terms Proposal 1 is acceptable to the company. It offers a rate of return of 15% ($0.15m/$1m) which is greater than the cost of capital. However, divisional ROI falls and this could lead to the divisional manager rejecting Proposal 1. This would be a dysfunctional decision. Residual income increases if Proposal 1 is adopted and this performance measure should lead to goal congruent decisions. In simple terms Proposal 2 is not acceptable to the company. The existing assets have a rate of return on 13% ($0.3m/$2.3m) which is greater than the cost of capital and hence should not be disposed of. However, divisional ROI rises and this could lead to the divisional manager accepting Proposal 2. This would be a dysfunctional decision. Residual income decreases if Proposal 2 is adopted and once again this performance measure should lead to goal congruent decisions. Relative merits of ROI and residual incomeReturn on investment is a relative measure and hence suffers accordingly. For example, assume you could borrow unlimited amounts of money from the bank at a cost of 10% per annum. Would you rather borrow £100 and invest it at a 25% rate of return or borrow $1m and invest it at a rate of return of 15%? Although the smaller investment has the higher percentage rate of return, it would only give you an absolute net return (residual income) of $15 per annum after borrowing costs. The bigger investment would give a net return of $50,000. Residual income, being an absolute measure, would lead you to select the project that maximises your wealth. Residual income also ties in with net present value, theoretically the best way to make investment decisions. The present value of a project's residual income equals the project's net present value. In the long run, companies that maximise residual income will also maximise net present value and in turn shareholder wealth. Residual income does, however, experience problems in comparing managerial performance in divisions of different sizes. The manager of the larger division will generally show a higher residual income because of the size of the division rather than superior managerial performance. In addition because RI uses the cost of capital to calculate an imputed interest this cost of capital can be adjusted to recognise the risk in different projects. Problems common to both ROI and residual incomeThe following problems are common to both measures:
PQR's cost of capital is 10% per annum. Straight line depreciation is used. Required:
Commentary: Non-financial performance indicators (NFPIs)In recent years, the trend in performance measurement has been towards a broader view of performance, covering both financial and non-financial indicators. The most well-known of these approaches is the balanced scorecard proposed by Kaplan and Norton. This approach attempts to overcome the following weaknesses of traditional performance measures: Single factor measures such as ROI and residual income are unlikely to give a full picture of divisional performance.
The term 'balanced' is used because managerial performance is assessed under all four headings. Each organisation has to decide which performance measures to use under each heading. Areas to measure should relate to an organisation's critical success factors. Critical success factors (CSFs) are performance requirements which are fundamental to an organisation's success (for example innovation in a consumer electronics company) and can usually be identified from an organisation's mission statement, objectives and strategy. Key performance indicators (KPIs) are measurements of achievement of the chosen critical success factors. Key performance indicators should be:
Example 3
The balanced scorecard approach to performance measurement offers several advantages:
Allowing for trade-offs between KPIs can also be problematic. How should the organisation judge the manager who has improved in every area apart from, say, financial performance? One solution to this problem is to require managers to improve in all areas, and not allow trade-offs between the different measures. Written by a member of the Performance Management examining team What is ROI how is it used in evaluating the performance of investment centers?ROI, being a percentage-return measurement, is consistent with how companies measure the cost of capital. For example, one can say that a company with an 8% ROI (before capital costs) is faring poorly if its cost of capital is 10%. 3. ROI is useful for people outside the company.
Why is the residual income a better measure for performance evaluation of an investment center manager than return on investment ROI?7. Residual income is a better measure for performance evaluation of an investment center manager than return on investment because: A) the problems associated with measuring the assest base are eliminated. B) desirable investment decisions will not be rejected by divisions that already have a high ROI.
Why is residual income a better measure of managerial performance compared to the ROI?It is also better to use residual income in the undertaking of the new project because the use of ROI will reject any potential projects. The reason for this is that ROI yields lower returns on the initial investment whereas the residual income will maximize the income and not the return on investment.
What is ROI in Management Accounting?Return on investment measures the ability of an investment to generate income. The ratio is used to compare alternative investment choices, as well as to determine if an existing investment represents an efficient use of resources.
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