How can analysis of budgets and comparison to actual results be used to evaluate

Question

How can analysis of budgets and comparison to actual results be used to evaluate performance of managers of multiple different divisions – particularly since the divisions may be of different sizes, have different amounts of resources invested in them, and may even buy or sell from each other? How can we specifically use comparison of budgeted to actual results, analysis of Return on Investment, measurement of Residual Income, as part of this process? Why is it important that Transfer Prices between divisions be carefully understood and managed?

Explanation / Answer

Answer

Answer 1

How can analysis of budgets and comparison to actual results be used to evaluate performance of managers of multiple different divisions – particularly since the divisions may be of different sizes, have different amounts of resources invested in them, and may even buy or sell from each other?

Divisionalization makes it easier for a company to diversify, while retaining overall strategic direction and control. Performance improvement is encouraged by assigning individual responsibility for divisional performance, typically linked to executive remuneration like bonuses, profit-sharing, share options etc.

Shareholder value is the criterion for overall business success, but divisional performance is the criterion for divisional success. Divisional performance measurement has also moved beyond financial measures to incorporate the drivers of financial results, i.e. non-financial performance measures.

So Analysis of budgets and comparison to actual results can be used to evaluate performance of managers of multiple different divisions for following purposes

Answer 2

How can we specifically use comparison of budgeted to actual results, analysis of Return on Investment, measurement of Residual Income, as part of this process?

Divisionalized business units may be:

Absolute profit is not a good measure for evaluating performance because it does not consider the investment in the business and how long-term profits can be affected by short-term decisions such as reducing research, maintenance and advertising expenditure. These decisions will improve reported profits in the current year, but will usually have a detrimental long-term impact. The performance of divisions and their managers can be evaluated using two methods: either return on investment or residual income.

Return on investment

The relative success of managers can be judged by the return on investment. This is the rate of return achieved on the capital employed. Using ROI, managerial and divisional success is judged according to the rate of return on the investment. However, a problem with this approach is whether a high rate of return on a small capital investment is better or worse than a lower return on a larger capital.

Residual Income (RI)

Residual income takes into account the cost of capital. Residual income is the profit remaining after deducting the notional cost of capital from the investment in the division. The RI approach has been compared with Economic Value Added, as both methods deduct a notional cost of capital from the reported profit.

The aim of managers should be to maximize the residual income from the capital investments in their divisions. However, the RI approach assumes that managers have the power to influence the amount of capital investment. But RI target is preferred to a maximization objective because it takes into account the differential investments in divisions, i.e. that a larger division should produce a higher residual income.

Answer 3

Why is it important that Transfer Prices between divisions be carefully understood and managed?

Transfer prices are almost inevitably needed whenever a business is divided into more than one department or division. Usually, goods or services will flow between the divisions and each will report its performance separately. The accounting system will usually record goods or services leaving one department and entering the next, and some monetary value must be used to record it. That monetary value is the transfer price. The transfer price negotiated between the divisions, or imposed by head office, can have a effect on the reported performance and subsequent decisions made.

Different transfer prices and different profits might have following effects on the divisions.

Performance evaluation: The success of each division, whether measured by return on investment (ROI) or residual income (RI) will be changed. These measures might be interpreted as indicating that a division’s performance was unsatisfactory and could tempt management at head office to close it down.

Performance-related pay: If there is a system of performance-related pay, the remuneration of employees in each division will be affected as profits change. If they feel that their remuneration is affected unfairly, employees’ morale will be damaged.

Make/abandon/buy-in decisions: If the transfer price is very high, the receiving division might decide not to buy any components from the transferring division because it becomes impossible for it to make a positive contribution. That division might decide to abandon the product line or buy-in cheaper components from outside suppliers.

Motivation: If a transfer price was such that one division found it impossible to make a profit, then the employees in that division would probably be demotivated. In contrast, the other division would have an easy ride as it would make profits easily, and it would not be motivated to work more efficiently.

Investment appraisal: New investment should typically be evaluated using net present value. However, the cash inflows arising from an investment are almost certainly going to be affected by the transfer price, so capital investment decisions can depend on the transfer price.

Taxation and profit remittance: If the divisions are in different countries, the profits earned in each country will depend on transfer prices. This could affect the overall tax burden of the group and could also affect the amount of profits that need to be remitted to head office.

So transfer prices can have a profound effect on group performance because they affect divisional performance, motivation and decision making. So it is important that Transfer Prices between divisions be carefully understood and managed.

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