MODULE 5 PERFORMANCE EVALUATION

MODULE 5 PERFORMANCE EVALUATION

OUTLINES Divisional profitability: Return on investment and residual income The distinction between economic and managerial performance evaluation. Economic Value added. Valued-based management. Transfer pricing (including cost-plus, market, negotiated and dual prices). Interaction of transfer pricing and taxation.

Divisional profitability: Return on investment and residual income In general, a large organisation can be structured in one of two ways: functionally (all activities of a similar type within a company, such as production, sales, research, are under the control of the appropriate departmental head) or divisionally (split into divisions in accordance with the products or services made or provided). Divisional managers are therefore responsible for all operations (production, sales and so on) relating to their product, the functional structure being applied to each division. It is possible, of course, that only part of a company is divisionalised and activities such as administration are structured centrally on a functional basis with the responsibility of providing services to all divisions. Return on investment (ROI) is a measure of the return on capital employed for an investment centre. It is also called the accounting rate of return (ARR). Return on investment (ROI) shows how much profit has been made in relation to the amount of capital invested and is calculated as (profit/capital employed) x 100%. It is often used as a measure of divisional performance for investment centres because: - the manager of an investment centre is responsible for the profits of the centre

and also the assets invested in the centre, and - ROI is a performance measure that relates profit to the size of the investment. Example DECO company has two divisions which are treated as investment centres for the purpose of performance reporting. Centre A has net assets of 5 million and made a profit of 250,000. Centre B has net assets of 1 million and made a profit of 150,000. If the performance of the centres is compared on the basis of profits, the performance of Centre A ( 250,000) is better than the performance of Centre B ( 150,000). However Centre A employed assets of 5 million to earn its profit and its ROI was just 5% ( 350,000/ 5 million). Centre B employed assets of just 1 million and its ROI was 15%. Comparing performance on the basis of ROI, Centre B performed better.

ROI and investment decisions The performance of the manager of an investment centre may be judged on the basis of ROI whether the division has succeeded or not in achieving a target ROI for the financial year, or whether ROI has improved since the previous year. If an incentive scheme is in operation, a divisional manager may receive a bonus on the basis of the ROI achieved by the division. Investment centre managers may therefore have a strong incentive to improve the ROI of their division, and to avoid anything that will reduce the ROI. This can be a serious problem when investment decisions are involved. When an investment centre manager s performance is evaluated by ROI, the manager will probably be motivated to make investment decisions that increase the division s ROI in the current year, and reject investments that would reduce ROI in the current year. The problem is that investment decisions are made for the longer term, and a new investment that reduces ROI in the first year may increase ROI in subsequent year. An investment centre manager may therefore reject an investment because of its short-term effect on ROI, without giving proper consideration to the longer term.

residual income Residual income is a measure of the centre's profits after deducting a notional or imputed interest cost. An alternative way of measuring the performance of an investment centre, instead of using ROI, is residual income (RI). Residual income is a measure of the centre's profits after deducting a notional or imputed interest cost. (a) The centre's profit is after deducting depreciation on capital equipment. (b) The imputed cost of capital might be the organisation's cost of borrowing or its weighted average cost of capital.

Illustration A division with capital employed of N400,000 currently earns an ROI of 22%. It can make an additional investment of N50,000 for a 5 year life with nil residual value. The average net profit from this investment would be N12,000 after depreciation. The division's cost of capital is 14%. What are the residual incomes before and after the investment? Before investment After investment N N Divisional profit (N400,000 x 22%) 88,000 100,000 Imputed interest (400,000 x 0.14) 56,000 (450,000 x 0.14) 63,000 Residual income 32,000 37,000

The advantages and weaknesses of RI compared with ROI The advantages of using RI (a) Residual income will increase when investments earning above the cost of capital are undertaken and investments earning below the cost of capital are eliminated. (b) Residual income is more flexible since a different cost of capital can be applied to investments with different risk characteristics. The weakness of RI is that it does not facilitate comparisons between investment centres nor does it relate the size of a centre's income to the size of the investment.

Economic Value added In theory, if a company makes a profit, the value of its shares ought to increase by the amount of the profit (less any dividends paid to shareholders). In practice, this does not happen. One reason for this is that in order to make a profit, capital is invested. Capital is a resource which has a cost. The actual creation of extra value should therefore be the profit less the cost of capital invested. Residual income is the accounting profit earned by a division less a notional charge for capital employed. In theory, there is a connection between residual income and the expected increase in the value of a business. Peter Drucker once wrote that: until a business returns a profit that is greater than its cost of capital, it operates at a loss. The potential benefits of EVA EVA is a measure of performance that is a close approximation of economic profit. Economic profit is measured in terms of the addition of economic value. An entity earns an economic profit only if it creates economic value through its activities. By creating economic value, a company should add to the wealth of its owners, the shareholders.

It measures the creation of value by a company, and is a more accurate measurement of performance than accounting profit. Economic value can be created when expectations of future profitability improve, because economic value can be measured as the net present value of future profits. EVA therefore recognises the benefit of activities, such as new investments, that add to longer-term profitability. Unlike accounting measures of profitability, EVA is not focused exclusively on the short-term. Management is encouraged to focus on the creation of value (EVA), which is in the long-term interests of shareholders. Management reward schemes based on EVA are likely to align the interests of management and shareholders more closely than a bonus system linked to annual accounting profits. It is a simple measure, like profit, and so one that line managers (including those with limited financial understanding) can understand. Measuring economic value added (EVA) Economic value added (EVA) for a financial period is the economic profit after deducting a cost for the value of capital employed. The formula for EVA is as follows: EVA = Net operating profit after tax (Capital employed Cost of capital) or EVA = NOPAT (Capital employed WACC) Where: WACC = Weighted average cost of capital

Jos Distribution Limited s income statement and statement of financial position for the year just ended are (year 1) as follows. Income statement Period 1 000 Profit before interest and tax 62,000 Interest cost (6,000) Profit before tax 56,000 Tax at 25% (14,000) Profit after tax 42,000 Dividends paid (24,000) Retained profit 18,000 Statement of financial position Period 1 000 Non-current assets 265,000 Net current assets 170,000 435,000 Shareholders funds 345,000 Long-term and medium-term debt 90,000 435,000

Additional information 1 Capital employed at the beginning of the year was 410 million. 2 The company had non-capitalised leased assets of 18 million in the year. These assets are not subject to depreciation. 3 The estimated cost of equity in the year 1 was 10% and the cost of debt was 7%. 4 The company s target capital structure is 50% equity and 50% debt. 5 Accounting depreciation was equal to economic depreciation so there is no need to make an adjustment to get from accounting depreciation to economic depreciation. 6 Other non-cash expenses were 14 million. Solution Net operating profit after tax Period 1 000 Profit after tax 42,000 Add: Interest cost less tax: (6,000 less 25%) 4,500 Add: Non-cash expenses 14,000 Net Operating Profit After Tax 60,500

Capital employed Year 1 000 Book value of total assets less current liabilities 410,000 Non-capitalised leased assets 18,000 428,000 WACC = (10% x 50%) + [7% (1 0.25) x 50%] = 7.625%. EVA Year 1 000 Net operating profit after tax 60,500 Capital charge: (428,000 x 7.625%) 32,635 Economic value added (estimate) 27,865

Transfer pricing (including costplus, market, negotiated and dual prices). Transfer price is the price which one division of an organisation charges for a product or service supplied to another division of the same organisation. Transfer prices are a way of promoting divisional autonomy, ideally without prejudicing the measurement of divisional performance or discouraging overall corporate profit maximisation. Transfer prices should be set at a level which ensures that profits for the organisation as a whole are maximised. Objectives of transfer pricing system The main-objectives of intra-company transfer pricing are as below: i) Emphasis on Profits ii) Maximum Utilisation of plant capacity iii) Optimise allocation of financial resources

Transfer pricing is used when divisions of an organisation need to charge other divisions of the same organisation for goods and services they provide to them. For example, subsidiary A might make a component that is used as part of a product made by subsidiary B of the same company, but that can also be sold to the external market, including makers of rival products to subsidiary B's product. There will therefore be two sources of revenue for A. (a) External sales revenue from sales made to other organisations. (b) Internal sales revenue from sales made to other responsibility centres within the same organisation, valued at the transfer price. General rules The limits within which transfer prices should fall are as follows. - The minimum. The sum of the supplying division's marginal cost and opportunity cost of the item transferred. - The maximum. The lowest market price at which the receiving division could purchase the goods or services externally, less any internal cost savings in packaging and delivery.

Cost-plus For the purpose of performance measurement and performance evaluation in a company with profit centres or investment centres, it is appropriate that: - the selling division should earn some profit or return on its transfer sales to other divisions and - the buying division should pay a fair transfer price for the goods or services that it buys from other divisions. Example PROTON has two divisions, Division C and Division D. Division C makes a component Y which is transferred to Division D. Division D uses component Y to make end-product Z. Details of budgeted annual sales and costs in each division are as follows: Division Division C D Units produced/sold 1,000 1,000 Sales of final product - 350,000 Costs of production Variable costs 70,000 30,000 Fixed costs 80,000 90,000 Total costs 150,000 120,000

The budgeted annual profit for each division if the units of component Y are transferred from Division C to Division D at full cost plus 20% are as follows. The full cost per unit produced in Division C is 150, and the transfer price (full cost plus 20%) is 180. Division Division Company C D as a whole Units produced/sold 1,000 1,000 1,000 External sales of final product - 350,000 350,000 Internal transfers (1,000 x 180) 180,000-0 Total sales 180,000 350,000 350,000 Costs of production Internal transfers (1,000 x 180) - 180,000 0 Other variable costs 70,000 30,000 100,000 Fixed costs 80,000 90,000 170,000 Total costs 150,000 300,000 270,000 Profit 30,000 50,000 80,000

Market Price Under this method, the transfer prices of goods/services transferred to other units/divisions are based on market prices. In a competitive market goods/services cannot be transferred to its users at a higher price. Such a competitive market provides an incentive to efficient production. Since market prices will, by and large be determined by demand and supply in the long run, it is efficiency of the various units. Competitive market prices provide reliable measures of divisional income because these prices are established independently rather than by individuals who have an interest in the results. The main limitations of this method are: i) Difficulty in obtaining market prices. ii) Difficulty in determining the elements of selling and distribution expenses such as commission, discounts, advertisement and sales promotion etc., so that necessary adjustment may be made in the market price to provide benefit of these expenses, to the profit centre, receiving the goods.

Illustration A company has two profit centres, A and B. A sells half of its output on the open market and transfers the other half to B. Costs and external revenues in an accounting period are as follows. A B Total N N N External sales 8,000 24,000 32,000 Costs of production 12,000 10,000 22,000 Company profit 10,000 Required What are the consequences of setting a transfer price at market value? Solution If the transfer price is at market price, A would be happy to sell the output to B for $8,000, which is what A would get by selling it externally instead of transferring it. A B Total N N N N N Market sales 8,000 24,000 32,000 Transfer sales 8,000 16,000 24,000 Transfer costs 8,000 Own costs 12,000 10,000 22,000 12,000 18,000 Profit 4,000 6,000 10,000 The transfer sales of A are self cancelling with the transfer cost of B, so that the total profits are unaffected by the transfer items. The transfer price simply spreads the total profit between A and B.

Consequences (a) A earns the same profit on transfers as on external sales. B must pay a commercial price for transferred goods, and both divisions will have their profit measured in a fair way. (b) A will be indifferent about selling externally or transferring goods to B because the profit is the same on both types of transaction. B can therefore ask for and obtain as many units as it wants from A. A market-based transfer price therefore seems to be the ideal transfer price. Negotiated Prices Under this method each decentralised unit is considered as an independent unit and such units decide the transfer price by negotiations or bargaining. Divisional managers have full freedom to purchase their requirement from outside if the prices quoted by their sister unit are lower. A system of negotiated prices develops business like attitude amongst divisions of the company. In order to avoid any reduction in overall profits of the company, the top management may impose restriction on the external purchase/sale of goods. In order to have an effective system of intra-company transfer pricing; the following points should be kept in view: 1) Prices of all transfers in and out of a profit centre should be determined by negotiation between the buyer and the seller 2) Negotiations should have access to full data on alternative sources and markets and to public and private information about market prices. 3) Buyers and sellers should be completely free to deal outside the company.

Dual prices This method combine both the cost method and market prices method in order to achieve goal congruence and encourage motivation. The features of both method are applied the dual price method.

Interaction of transfer pricing and taxation Transfer pricing policies affect the motivation of managers. However, in multinational companies, other factors may dominate. Multinational companies use transfer prices to minimize worldwide income taxes, import duties, and tariffs. For example, Nike might prefer to make its profits in a country, with its maximum corporate tax rate of 30%, rather than in some other place where the rate is 35%. Suppose a division in a high-income-tax-rate country produces a sub-assembly for another division in a low-income-tax-rate country. By setting a low transfer price, the company can recognize most of the profit from the production in the low-income-tax-rate country, thereby minimizing taxes. Likewise, items produced by divisions in a low-income-tax-rate country and transferred to a division in a high-income-tax-rate country should have a high transfer price to minimize taxes. Sometimes import duties offset income tax effects. Most countries base import duties on the price paid for an item, whether bought from an outside company or transferred from another division. Therefore, low transfer prices generally lead to low import duties.

Revision questions 1. State five problems with transfer pricing. 2. The performance of an investment centre is usually monitored using either or both of return on investment (ROI) and residual income (RI). Discuss 3. A company is organised on decentralised lines, with each manufacturing division operating as a separate profit centre. Each divisional manager has full authority to decide on sale of the division s output to outsiders and to other divisions. Division C has always purchased its requirements of a component from Division A. But when informed that Division A was increasing its selling price to N150, the manager of Division C decided to look at outside suppliers. Division C can buy the component from an outside supplier for N135. But Division Are fuses to lower its price in view of its need to maintain its return on the investment. The top management has the following information : C s annual purchase of the component 1,000 units A s variable costs per unit N 120 A s fixed cost per unit N20

Required : (i) Will the company as a whole benefit, if Division C bought the component at N135 from an outside supplier? (ii) If A did not produce the material for C, it could use the facilities for other activities resulting in a cash operating savings of N18,000. Should C then purchase from outside sources? (iii) Suppose there is no alternative use of A s facilities and the marker price per unit for the component drops by N20. Should C now buy from outside?

References 1. ANAN Professional Examination Study Pack. 2. ACCA professional Examination Study Pack. 3. Drury, C. (2012). Management & Cost Accounting 8 th Edition Centage publishing. 4. Advanced Management Accounting (2011) ICAI. Vol. 1