Divisional Performance Measurement
Control
Divisional Performance Measurement
Syllabus tag: KASNEB CPA | Intermediate Level | CA25 Management Accounting | Topic 9 Divisional Performance Measurement
Lesson objectives
By the end of this topic, you will be able to:
- Distinguish cost, profit and investment centres
- Compute return on investment and residual income
- Show how ROI can cause a manager to reject a worthwhile project
- Set a minimum transfer price with and without spare capacity
- Explain goal congruence and why it can fail
Why this matters
Once a company is large enough to divide into divisions, it has to measure them. The measure chosen changes the decisions managers make — and the wrong measure makes good managers do the wrong thing.
Types of responsibility centre
| Centre | Manager controls | Measured on |
|---|---|---|
| Cost centre | Costs only | Cost variances |
| Profit centre | Costs and revenues | Profit |
| Investment centre | Costs, revenues and assets | ROI or RI |
A manager should be judged only on what they control. Charging a cost centre manager with apportioned head office costs measures head office, not them.
Two divisions throughout
| Division A | Division B | |
|---|---|---|
| Profit | KES 4,200,000 | KES 1,800,000 |
| Investment | KES 21,000,000 | KES 12,000,000 |
The group cost of capital is 12%.
Return on investment
ROI = Divisional profit / Divisional investment
- Division A = 4,200,000 / 21,000,000 = 20%
- Division B = 1,800,000 / 12,000,000 = 15%
A percentage, so divisions of different sizes can be compared. That is its attraction and also its flaw.
Residual income
RI = Divisional profit − (Cost of capital × Investment)
- Division A = 4,200,000 − (0.12 × 21,000,000) = KES 1,680,000
- Division B = 1,800,000 − (0.12 × 12,000,000) = KES 360,000
An absolute figure in shillings. It answers a different question: not "what rate did we earn" but "how much did we earn above the minimum required".
Where the two disagree
A new project offers profit of KES 700,000 on an investment of KES 4,000,000.
Project ROI = 700,000 / 4,000,000 = 17.5% Project RI = 700,000 − (0.12 × 4,000,000) = KES 220,000
The project earns 17.5% against a 12% cost of capital, so the group should want it. Now look at what it does to each division.
| A before | A after | B before | B after | |
|---|---|---|---|---|
| ROI | 20.0% | 19.6% | 15.0% | 15.6% |
| RI | 1,680,000 | 1,900,000 | 360,000 | 580,000 |
Division A's manager, judged on ROI, would reject it. Accepting a project returning 17.5% drags a 20% average down to 19.6%, and the manager's performance measure worsens even though the group is better off by 220,000.
Residual income rises in both divisions, because RI asks only whether the return beats the cost of capital.
This is the central criticism of ROI: it encourages managers to reject any project returning less than their current average, however comfortably it beats the cost of capital.
:::checkpoint Division B's manager, judged on ROI, would accept the same project that Division A's manager rejects. Explain why, and say what that shows about using ROI to compare managers. :::
Other weaknesses of both measures
- Asset age. A division with old, heavily depreciated assets shows a small investment base and a flattering ROI. Replacing them worsens the measure.
- Short-termism. Cutting maintenance, training or research lifts this year's profit and both measures with it.
- RI is not comparable across sizes. A large division will usually show a larger RI simply because it is larger, which is why ROI survives.
Most groups report both, and neither alone.
Transfer pricing
When one division sells to another, the price affects each division's reported profit while changing nothing for the group.
The general rule: minimum transfer price = marginal cost + opportunity cost of the supplying division.
A component costs KES 340 in variable cost and sells externally at KES 500.
- With spare capacity, nothing is given up by supplying internally, so the minimum is the marginal cost of KES 340.
- At full capacity, supplying internally means losing an external sale, so the opportunity cost of 160 is added: minimum KES 500, the market price.
Set the price below the minimum and the supplying division refuses work that benefits the group. Set it above what the buying division can bear and it buys outside, again harming the group.
Goal congruence
Goal congruence exists when a manager pursuing their own performance measure happens to do what is best for the group. The ROI example above shows it failing: A's manager acts rationally on the measure given and the group loses 220,000.
The lesson is not that managers behave badly. It is that a performance measure is an instruction, and a poorly chosen one instructs people to do the wrong thing.
:::checkpoint A divisional manager is judged on ROI and is nearing retirement. Explain why the company's ageing machinery is unlikely to be replaced, and suggest one change to the measurement system that would help. :::