Question

Internal 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

1) Midland Division Northern Division    East Division

$ $

Sales 1,580,000 1,560,000 1,112,000

Controllable cost of goods sold 650,000 620,000 380,000

Contr. Gross profit 930,000 940,000 732,000

(1,580,000-650,000)   

Non-controllable cost of goods sold 116,000 115,000 100,000

Gross profit 814,000 825,000 632,000

(930,000-116,000)

Controllable Selling general & Administrative overheads 370,000 400,000 370,000

Non-controllable Selling general & Administrative

overheads 250,000 250,000 162,000

Profit before tax 194,000 175,000 100,000

(814,000-370,000-250,000)

Controllable profit 560,000 540,000 362,000

Total costs 1,386,000 1,385,000 1,012,000

Controllable costs 1,020,000 1,020,000 750,000

Non-controllable costs 366,000 365,000 262,000

Total investment 1400000 1440000 850000

Controllable investment 1200000   1111000 800000

Interest Charge (1) 140,000   144,000 85,000

Interest Charge (2 ) 120,000 111,100 80,000

Net Residual Income 54,000 31,000 15,000

Controllable RI 440,000   428,900 282,000

ROI 13.86% 12.15% 11.76%

(194000/1400000*100)

Return on sales 12.28% 11.22% 8.99%

(194,000/1,580,000*100)

Ratios:-

% controllable costs 73.59% 73.65% 74.11%

Cost by sales:-

% controllable / sales 64.56% 65.38% 67.45%

% non-controllable / sales 23.16% 23.40% 23.56%

PBT by  sales 12.28%     11.22% 8.99%

Total 100.00% 100.00% 100.00%

Controllable profit by sales 35.44% 34.62% 32.55%

Controllable profit by controllable capital employed 46.67% 48.60% 45.25%

ROI = Profit/ investment*100

ROS= Profit/total sales*100

2) Make the choice of performance measures for the 3 divisions

There must be a link between strategy and performance measures

Very unlikely that all divisions have the same strategy and measure

Other measures that are important:-

Market share, More quality measures, Details of new product development

3) What assets are included - how are they valued

What assets are not controllable, What assets are idle

Should liabilities be included or excluded

Gross book value or net book value or market value

Cost of getting information for market values

4)Behavioural problems

Examples of division with high ROI rejects good investment because ROI not quite as good. Lowers overall ROI

Company with low ROI accepts investment which improves overall ROI but gives return below cost of capital.

5) Currency translation – manager uses local currency but head office wants resultsin home currency.

Changes is exchange rate can make manager look good or bad.

Problems of criticising manager for decline in exchange rate

Cultural and language barriers–limits to number of foreign managers!

Income taxesComplicated reporting requirements

Volume of reports, Relative inflation

Legal differences can complicate evaluation, Import duties / tariffs, Management charges