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Chapter 13. Strategic and Divisional Performance Appraisal. Organisational structure. Performance measurement is directly linked to the organisational structure of a business. a distinction can be made between two categories of organisational structure for performance appraisal:
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Chapter 13 Strategic and Divisional Performance Appraisal
Organisational structure • Performance measurement is directly linked to the organisational structure of a business. • a distinction can be made between two categories of organisational structure for performance appraisal: • Functional organisation structures. • Divisionalised organisation structures.
CEO Women’s Clothing Men’s Clothing Children’s Clothing Other retail departments… Admin. Stores Other functions… Functional organisation structures • A functional organisation structure is where a business is divided into separate departments such as operations and purchasing along with separate support departments such as administration, accounting, marketing and sales. The managers of each department are only responsible for their part in the process of ensuring the provision and sale of a product or service.
CEO Dublin Division Cork Division Limerick Division Other locations… Women’s Clothing Women’s Clothing Women’s Clothing Men’s Clothing Men’s Clothing Men’s Clothing Children’s Clothing Children’s Clothing Children’s Clothing Other retail departments Other retail departments Other retail departments Admin. Admin. Admin. Stores Stores Stores Other functions… Other functions… Other functions… Divisionalised organisation structures • A divisionalised or decentralised organisation structure occurs where the organisation is broken into divisions in accordance with the products or services offered. Each divisional manager is responsible for all the operations relating to their particular product or service. Thus the autonomy experienced at CEO level in a functional organisation is similar to that experienced by a divisional head in a decentralised organisation structure.
Performance measurement in a divisionalised setting • These performance measurement systems depend on the degree of decentralisation involved. There are four recognised levels of decentralisation as follows: • Cost centres. • Revenue centres. • Profit centres. • Investment centres.
Cost centre • This is where the manager of such a centre or division is responsible for the costs associated with that centre and hence the main focus is cost minimisation. This level of decentralisation occurs normally in functional organisation types. The key measures used in appraising performance for a cost centre would be cost variances from budget and individual cost items (labour for example), as a percentage of total costs.
Revenue centre • This is where the manager is totally concerned with raising revenue with no responsibility for costs. The key measures used in appraising performance would be monitoring sales variances from budget.
Profit centre • This is where the manager of such a centre or division has responsibility for both revenue and costs for the assets assigned to the division. Thus performance is measured in terms of the difference between the revenues and costs that relate to a profit centre. A profit centre is like a separate company with its own profit and loss account and the manager’s decisions relate to the revenue and costs that make up the divisions profit statement. The main performance measures focus on cost and revenue variances to budget, as well as the preparation of key profit ratios such as gross profit percentage, operating profit percentage and expenses to sales percentages.
Investment centre • This is where the manager has responsibility for not just the revenues and costs relatingto the centre, but also the assets that generate these costs and revenues and the investment decisions relating to disposal and acquisition of assets. For managers of investment centres, the main performance measures used will be based on return on investment and breaking that down into its two component parts namely operating profit margin and capital employed turnover (asset turnover). Two measures of divisional performance most commonly used are: • Return on investment (ROI). • Residual income.
Return on investment (ROI) • Return on investment (ROI) is very similar to return on capital employed (ROCE) except the focus is on controllable and traceable revenues, expenses and assets. • Return on investment (ROI) = Divisional net profit x 100 Divisional net assets
Residual income • The residual income is profit earned less interest on the capital that has been employed to generate the profit.
Financial performance measures in divisionalised organisations
A good performance measure should • Provide incentive to the divisional manager to make decisions which are in the best interests of the overall company (goal congruence). • Only include factors for which the divisional manager can be held accountable. • Recognise the long-term objectives as well as short-term objectives of the organisation.
Advantages of return on investment • It is a financial accounting measure that is understandable to managers. • ROI can be further analysed into its component parts of capital employed turnover (asset turnover) and operating profit margin. These ratios can be further divided into their component parts. This can help management understand the drivers behind ROI and hence work to improve the ROI. • ROI is a common measure and thus is ideal for comparison across corporate divisions for companies of similar size and in similar sectors.
Disadvantages of return on investment • The level of investment or capital employed can be difficult to measure and this can distort inter-firm comparisons. For example, comparing ROI for hotels that periodically revalue their property assets to those that don’t, can be misleading. The companies with the revalued properties will have a higher asset base and hence a lower return on investment. If assets are valued at net book value, ROI and residual income figures generally improve as assets get older. This can encourage managers to retain outdated plant and machinery. • Different accounting policies will affect both profits and asset or investment values. Thus inter-firm comparisons can be very misleading if the companies involved do not have similar accounting policies with regard to fixed assets, stocks and certain intangible assets such as research and development. • The use of ROI can lead to dysfunctional decisions made by managers as illustrated in example 13.2.
Advantages of residual income • Residual income is considered a better overall performance measure as it is an absolute measure, whereas return on investment is a relative measure and hence suffers accordingly. As illustrated in example 13.2, the use of ROI can lead to dysfunctional decisions. Residual income, being an absolute measure, can lead management to make decisions that maximise the wealth of the business.
Disadvantages of residual income • It can be difficult to calculate a minimum required return (cost of capital) for a business or division. • As with the return on investment, identifying the appropriate value for investment or assets can be difficult and subjective. • Residual income is not as well understood and known by managers as return on investment.
Transfer pricing • Transfer pricing occurs where an organisation structures itself into separate independent divisions. When separate divisions within the organisation buy and sell to and from one another, then transfer pricing occurs. The transfer price is the cost of buying the product in the buying division and is the sales revenue for the selling division. The level of the transfer price will affect the profitability of both divisions and thus has performance appraisal implications. An agreed price must be found that is fair to both divisions.
Transfer pricing • Set full cost price as the transfer price. This however is very harsh on the selling division and undermines its profitability and hence its performance appraisal. • Set cost plus a mark-up as the transfer price. This system would help ensure the selling division has some element of profit on the transaction. • Set market price as the transfer price. This is a feasible option where prices would be set, based on listed prices of identical products or services, or, on a price a competitor is quoting. • Set a transfer price based on negotiation between the managers of the buying and selling divisions. This option often has behavioural benefits, as managers develop an understanding of each others problems.
Limitations of traditional financial performance measures • Accounting measures are historical and backward looking in nature. • Accounting measures only present a limited picture of a business’s performance. • Accounting indicators can focus too much on the short-term and can give rise to short-term decisions that could have a harmful effect on the business in the future. • Traditional financial measures tend to be quite inward looking and not focused on external factors such as customers and competitors. • Financial analysts and capitalists are increasingly taking the view that the intangible assets of a business are more likely to create future value. However, these assets are so subjective to measure in financial terms, that they are often ignored. • Accounting measures can ensure the focus is on cost rather than value. • Single factor measures are capable of distortion by unscrupulous managers. • They are of little use as a guide to action. If ROI or residual income fall, they simply indicate that performance has decreased, without indicating why.
Non-financial performance indicators • In recent years, the trend in performance measurement has been towards a broader view of performance, covering both financial and non-financial indicators. By focusing solely on financial performance measures, it is unlikely that a full picture of divisional performance can be obtained. .
Non-financial performance indicators • Financial performance, focusing on profitability, liquidity, efficiency, capital structure and market ratios. • Competitiveness, which measures market share, position and sales growth • Resource utilisation, focusing on productivity, efficiency and asset utilisation. • Quality of service, which focuses on several measures of service quality including reliability, responsiveness, cleanliness, comfort, friendliness, courtesy, communications and competence security. • Innovation, measuring the proportion of new to old products and services, as well as new products and service sales levels. • Flexibility, measured in terms of volume as well as delivery speed, and product or service specification flexibility. Fitzgerald et al (1991)
The balanced scorecard • The balanced scorecard system was developed from research undertaken by Professor Robert Kaplan (Harvard Business School) and David Norton (management consultant). The research was based on the belief that managers need a broad range of performance measures in order to manage their businesses and that existing financial performance measures were not enough and actually limited a businesses ability to create economic value.
The balanced scorecard • The balanced scorecard provides a framework that translates the aims and objectives of a business into a series of performance targets that can be measured. Performance is measured and the link to strategy ensures that management can see if strategic objectives are being achieved.
Balanced scorecard Financial perspective How do we look to our shareholders? Innovation and learning perspective How can we continue to improve and create value? Customer perspective How do customers see us? BALANCED SCORECARD Internal business perspective What must we excel at?
The balanced scorecard • The financial perspective, focusing on traditional financial measures such as sales growth, profit, return on capital and shareholders value. • The customer perspective, focusing on corporate customers service objectives in terms of measures that correspond to customers priorities. Performance measures for customers would include customer satisfaction levels, customer retention and growth in customer numbers. • The internal business processesperspective, focusing on what the business must excel at and on the internal processes, decisions and actions, if the business is to meet customer requirements. • Innovation and learning perspective, focusing on how a business can continue to improve and create value. It measures how a business seeks to learn, innovate and improve every aspect of the organisation. The fact that it exists and is being measured, forces businesses to become aware of and to monitor their propensity to innovate, retrain, up-skill and improve performance in the face of competition.
The balanced scorecard • The term 'balanced' is used because managerial performance is assessed under all four headings and it implies that each quadrant is of equal importance and deserves equal weighting. • This can help senior management evaluate whether lower level managers have improved one area at the expense of another. • The balanced scorecard will recognize the improvement in financial performance but will also reveal that this was achieved by sacrificing ‘on-time’ performance targets
Critical success factors (CSF) and key performance indicators • When using the balanced scorecard, an 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 (CSF) • 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 • Key performance indicators (KPIs) are measurements of achievement of the chosen critical success factors. Key performance indicators should be: • Specific: For example, measure profitability rather than 'financial performance', a term which could mean different things to different people. • Measurable: Key performance indicators must be capable of having a measure placed upon them, for example, number of customer complaints rather than the 'level of customer satisfaction'. • Relevant: Key performance indicators must relate to and measure the achievement or non-achievement of a critical success factor.
Commonly Used Measures (KPI) in Balanced Scorecard (UK) Source: A Practical Guide to the Balanced Scorecard (CIMA)
The balanced scorecard in Hospitality Louvieris et al
Advantages of the balanced scorecard • It measures performance in a variety of ways, rather than relying on one figure. • Managers are unlikely to be able to distort the performance measure as bad performance is difficult to hide if multiple performance measures are used. • It takes a long-term, strategic approach to business performance. • Success in the four key areas should lead to the long-term success of the organisation. • It is flexible, as what is measured can be changed over time to reflect changing priorities. • 'What gets measured gets done'. If managers know they are being appraised on various aspects of performance, they will pay attention to these areas, rather than simply paying 'lip service' to them.
Disadvantages of the balanced scorecard • Setting standards for each of the key performance indicators can prove difficult where the organisation has no previous experience of performance measurement. Benchmarking with other organisations is a possible solution to this problem. • Allowing for trade-offs between key performance indicators can be problematic. How should an organisation judge a 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.
