Performance Management for Divisions and Balanced Scorecard. Prof. Dr. Carsten Berkau. Prof. Dr. Carsten Berkau

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1 Seite: 1 Performance Management for Divisions and Balanced Scorecard Prof. Dr. Carsten Berkau 1.1 Accounting Based Performance Measurement

2 Seite: 2 Divisional Financial Performance Measue Divisional managers are supposed to pursue goals that are in the best interest of the company as a whole. - functional organisational structure: (1) Marketing is revenue center, (2) all other departments are cost centers - divisional organiational structure: functional strukture is applied within every devision. Devisions are investments centers or profit centers. => Consequently, the functional managers in a centralised organisation will have far less independence than divisional managers Advantages and Disadvantages of Divisionalisation - Advantages (1) Quality of decision (person is familiar) (2) Speed of decision (no chain of command) (3) Higher motivation of managers (more freedom) (4) Frees top management, training ground for divisional managers - Disadvantages (1) Competition between divisions (2) Lack of harmony (3) Top management loses control

3 Seite: 3 Managerial vs. Economic Performance Drury example: (1) Manager improves performance, but division is still unprofitable because of industry factors, as overcapacity or declining market. (2) Otherwise division reports significant profit, but performance is unsatisfactory when favourable economic environment is taken into account. => If purpose is to evaluate the divisional manager only those items directly controllable by management should be included in the profitablity measure => To measure economic performance many items the divisional manager cannot influence (interest rate, taxes,...) should be included in the profitablity measure Alternative Divisional Profit Measures Ensheim AG's PROFIT STATEMENT for 20X1 Sales [R] Sales to outside customers ,00 Transfers to other divisions ,00 Total sales revenue ,00 less Variable costs ( ,00) (1) Variable short-run CM ,00 less Controllable fixed costs ( ,00) (2) Controllable contribution ,00 less Non-controllable avoidable cost (50.000,00) (3) Divisional contribution ,00 less Allocated corporate exp. ( ,00) (4) Divisional NP before taxes ,

4 Seite: 4 Performance Measures (1) Return on Investment (2) Residual income (3) EVA (TM) Return on Investment Division X Division Y Prososed investment , ,00 Controllable contribution , ,00 Return on proposed project 0,20 0,13 ROI of the other divisions 0,25 0,

5 Seite: 5 Residual Income Division X Division Y Prososed investment , ,00 Controllable contribution , ,00 Cost of capital charge (15%) ( ,00) ( ,00) Residual income ,00 ( ,00) EVA (TM) Division X Division Y Prososed investment , ,00 Controllable contribution , ,00 Cost of capital charge (13.8%) ( ,00) ( ,00) Residual income ,00 (80.000,00) EVA requires adjustments for cost of capital. (= WACC x (Asset curr. Liabilities)

6 Seite: 6 Determining which Assets should be Included in the Investment Base The asset base is to be considered for ROI and EVA. - Manager performance vs. economic performance: Only those assets can directly traced to the devision that are controllable by the division manager. No assets are to be considered that are under control of central HQ., like debtors or cash. If influenced by the manager they are to be included in the investment base - Deduct all liabilities that are within control of the divisionfrom asset base - Many divisionalised companies allocate corporate assets to divisions in order to compare profitability of division and firms in the same industry Profitability Measures using Straight Line Method for Depr. 20X1 20X2 20X3 Net CF , , ,00 Depreciation ( ,00) ( ,00) ( ,00) Profit , , ,00 Cost of capital (10% CA) ( ,00) (80.000,00) (60.000,00) EVA , , ,00 OV (=CA) on , , ,00 ROI 0,15 0,19 0,

7 Seite: 7 Profitability Measures using Straight Line Method for Depr. 20X1 20X2 20X3 Net CF , , ,00 Depreciation ( ,00) ( ,00) ( ,00) Profit , , ,00 Cost of capital (10% CA) ( ,00) (80.000,00) (60.000,00) EVA , , ,00 OV (=CA) on , , ,00 ROI 0,15 0,19 0, Comparison ROI vs. CFROI Example: Someone is goring to establish a taxi business Drury, Schulte, C.: Lexikon [2007]: des Management Controlling. München: and Cost Oldenbourg Accounting. 1996, S th

8 Seite: 8 Comparision of ROI vs CFROI Assume fulfillment of assumptions for planning and inflation rate to be 5% to get the following situation: 1.23 Drury, Schulte, C.: Lexikon [2007]: des Management Controlling. München: and Cost Oldenbourg Accounting. 1996, S th Solution: Internal interest rate r is realised when PV of investment becomes zero. 5 (1+ r) = r (1+ r) (1+ r) 5 Assumption: Acquisition in t = 0, use during t = Instead of isolating r we follow iterative approach. Using MS-Excel you can use result approximation. Use formula as follows: *(POTENZ(1+B4;5)-1)/(B4*(POTENZ(1+B4;5)))+(1000/(POTENZ(1+B4;5))) Iterations gives you internal interest rate to be 15,6%. 1.24

9 Seite: 9 Impact of Depreciation (New Example) X Y Z Machine at Cost (t=0) , , ,00 Estimated CF (t=1) , , ,00 Estimated CF (t=2) , , ,00 Estimated CF (t=3) , , ,00 PV ,84 (51.909,09) ,14 Rank => Present value is long-run best performance indicator when using correct interest rate for discounting (WACC) 1.25 Estimated Profit and ROI X Y Z Machine at Cost (t=0) , , ,00 Estimated CF (t=1) , , ,00 Estimated CF (t=2) , , ,00 Estimated CF (t=3) , , ,00 Profit (t=1) (37.000,00) ,00 ( ,00) Profit (t=2) ,00 (37.000,00) ( ,00) Profit (t=3) , , ,00 Total of profit , , ,00 CA (t=1) , , ,00 CA (t=2) , , ,00 CA (t=3) , , ,00 ROI (t=1) -4% 12% -28% ROI (t=2) 14% -6% -41% ROI (t=3) 88% 15% 283% Average ROI 0,33 0,07 0, Example considers straight line methode for depreciation. Useful life is 3 years.

10 Seite: 10 Estimated Profit and ROI X Y Z Machine at Cost (t=0) , , ,00 Estimated CF (t=1) , , ,00 Estimated CF (t=2) , , ,00 Estimated CF (t=3) , , ,00 Profit (t=1) (37.000,00) ,00 ( ,00) Profit (t=2) ,00 (37.000,00) ( ,00) Profit (t=3) , , ,00 Total of profit , , ,00!!! CA (t=1) , , ,00 CA (t=2) , , ,00 CA (t=3) , , ,00 ROI (t=1) -4% 12% -28% ROI (t=2) 14% -6% -41% ROI (t=3) 88% 15% 283% Average ROI 0,33 0,07 0, Example considers straight line methode for depreciation. Useful life is 3 years. EVA (TM) X Y Z Machine at Cost (t=0) , , ,00 Estimated CF (t=1) , , ,00 Estimated CF (t=2) , , ,00 Estimated CF (t=3) , , ,00 Profit (t=1) (37.000,00) ,00 ( ,00) Profit (t=2) ,00 (37.000,00) ( ,00) Profit (t=3) , , ,00 10% interest on CA (t=1) , , ,00 10% interest on CA (t=2) , , ,00 10% interest on CA (t=3) , , ,00 EVA (t=1) ( ,00) ,00 ( ,00) EVA (t=2) ,00 (94.400,00) ( ,00) EVA (t=3) , , ,00 PV all EVAs ,84 (51.909,09) , Example considers straight line methode for depreciation. Useful life is 3 years.

11 Seite: 11 Dysfunctional Consequences of Short-Term Financial Performance Measures Sometimes divisional managers follows short-term performance measures that lead to wrong decisions: (1) Taking ROI (t=1) instead of present value: Y instead of X (2) Taking EVA (t=1) instead of present value: Y instead of X To avoid such mistakes: (1) use difference in VIU (2) use EVA, but issue because of historic cost model (3) lengthen period (4) take non-financial data into consideration 1.29 Ratios for Different Life Cycle Levels There are 3 levels of life cycle for a devision: Growth Divisions deal with products with high potential to grow. For that there are enormous resources required to develop and support (marketing) products. Growth divisions can have negative cash flows and low returns. The divisions aims to maximise revenue to reach market shares. Matuity In phasis of maturity investment are still relevant but only to reach returns. Divisions are related to returns. They try to increas shareholder value. Harvest In last phasis of life cycle the division does not invest any more. The division tries to increase cash flows and to reduce net operating assets. 1.30

12 Seite: 12 Ratios Ratios show profit related to input. There are: (1) Gross margin (2) Return on Investment (3) Return on capital employed (4) Return on assets Furthermore there are concepts that deal with measurement of ratios, like: (1) CFROI - Cash flow return on investment (2) EVA - Economic value added 1.31 Problems of Ratios Problems of Ratios are: Gross margin does not say anything about performance only about the sales margin. (How good are we selling our products, are they good) ROCE Leverage Effect influences ROE ratio ROI ROI and ROA get changed by age of used assets. 1.32

13 Seite: 13 BSC 1.33 BSC FINANCIAL Objectives Measures Targets Initiatives CUSTOMER Objectives Measures Targets Initiatives VISION AND STRATEGY INTERNAL BUSINESS PROCESS Objectives Measures Targets Initiatives LEARNING AND GROWTH Objectives Measures Targets Initiatives 1.34

14 Seite: 14 4 Perspective Questions: - FINANCIAL PERSPECTIVE To succeed financially, how should we appear to our shareholders? - CUSTOMER PERSPECTIVE To achieve our vision how should we appear to our customers? - INTERNAL BUSINESS PERSPECTIVE To satisfy our shareholders and customers what business processes must we excel at? - LEARNING AND GROWTH PERSPECTIVE To achieve our vision, how will we sustain our ability to change and improve? 1.35 Financial Perspective - Revenue growth: (1) Increase the number of new products (2) Develop new customers and markets (3) Change to a more profigable product/service mix - Cost reduction: (1) Reduce product/service cost per unit (2) Reduce selling costs, reduce general admin costs - Asset utilisation: (1) Improve asset utilisation 1.36

15 Seite: 15 Financial Perspective - Core: (1) Increase market share (2) Increase customer retention (3) Increase customer acquisition (4) Increase customer satisfaction (5) Increase customer profitability - Customer value propositions: (1) Improve product functionality (2) Decrease price relative to competitors (3) Inprove product quality, improve service quality (4) Inprove delivery time 1.37 Internal Business Perspective - Innovation: (1) Increase number of new products (2) Develop new markets and customers (3) Decrease the time taken to develop new products. - Operations: (1) Increase process efficiency (2) Increase process quality (3) Decrease process cost (4) Decrease process time - Post-sales service: (1) Increase service quality (2) Increase service efficiency (3) Decrease service time (4) Decrease service cost 1.38

16 Seite: 16 Learning and Growth Perspective - Increase employee capabilities: - Increase information system capabilities: - Increase motivation, empowerment and alignment: 1.39 Cause-and and-effect-relationship GROWTH PROCESS CUSTOMER FINANCE Decrease process time Increase EVA Increase customer satisfaction Increase Know how Decrease Process costs 1.40

17 Seite: 17 Limitation of BSC Concept (1) Four overloaded perspectives (2) Framework, process model (3) Consideration of measures together (4) Improvement of communication (5) Cause-and-effect relationship requires empirical support (6) Suggested framework can be enhanced, but beware of temptation to create too many new perspectives (7) Related to manufacturing business 1.41