Names

KyriakiXenofontos P1320631X

ConstantinaChristodoulou P13189107

RevekkaKatsounotou P13195271

19 March 2015

Lecturer’s Mr. Tom Webster

ModuleTitle and Module Code: Decision Management– ACFI 2420

Assignment ManagementAssignment 2

Wordcount:

SUMMARY

There are two types of decision managementthat are analyzed in this research. These decision managements areused as a performance measure for various divisions in a firm. Inthis research, I have started by introducing you to the paper. Thereis a review of measuring division’s performance for the year 2013and 2014 for Sador Plc. The paper as well has suggestions forimproving divisions’ performance. There is evaluation of threevarious performance measures. The three performance measures analyzedin this research are Residual Income (RI), ROI and Economic ValueAdded (EVA). There is as well a section that shows you how tocalculate as well as differentiate the three measures under variouscircumstances for divisions. An evaluation of how suitable thesemeasures are to our business is as well discussed in this research.

Content list

Introduction……………………………………………………………………………………………4

PartA…………………………………………………………………………………………………….5-18

Draftbudget……………………………………………………………………………….5

ProposalA………………………………………………………………………………….7

ProposalB………………………………………………………………………………….9

ProposalC…………………………………………………………………………………11

Graphs………………………………………………………………………………………13

Bestproposal…………………………………………………………………………….17

Non-financialfactors…………………………………………………………………18

PartB…………………………………………………………………………………………………..19-22

Question(a)………………………………………………………………………………20

Question(b)………………………………………………………………………………21

Question(c)……………………………………………………………………………….22

Conclusion……………………………………………………………………………………………23

References……………………………………………………………………………………….…..24

Introduction

Thereare so many business disciplines that enable any commercialorganization to run well. Decision management is one of the veryvital business disciplines for any firm. Decision management isdiscipline of business which enables companies not only tosystematize but to enhance as well as manage repeatable decisionsthat concerns a business. EVA, RI and ROI are performance measuresthat are mostly used by top managers of a firm so as to provide aconsistency in evaluating managers of various divisions of abusiness. It is easier for top managers to know how the firm isfairing on at the moment as well as the future using theseperformance measures. They analyze and evaluate each division in thebusiness.

  1. Measuring division’s performance for 2013 and 2014

Regardingthe profit of the FC division, there is an increase between 2013 and2014 of £42,400. However, we cannot comment on the division’sprofitability because we must consider whether the return on theinvested capital is satisfied( Drury, 2012). The Return on Investment(ROI) in 2013 was 14.12% and in 2014 has risen to 19%. Thereforethere is an increase in the division’s performance and the companyis more profitable in 2014 since it earns a higher return on theinvestment. However, this is not enough as ROI must be above thecompany’s cost of capital in order to be beneficial for thecompany. In both years ROI is higher than the cost of capital of 8%,which indicates a good performance by the division. Furthermore, thedivision has invested more in 2014 which is the consequence of aneffective performance.

Consideringthe Residual Income (RI), it has also been increased by 37,472 whichis a positive element of the division’s performance. This showsthat the shareholders wealth has been maximized since the profit madeexceeds the required level (CIMA, online). In other words, the FCdivision has met the minimum return requirement. Both in 2013 and2014 the division is performing well and the manager is encouraged toinvest since the RI is a positive figure in both years. Overall, FCdivision performs well in both years with even more efficientperformance in 2014.

  1. Suggestions for improving divisions performance

Thedivision can improve its productivity results in future years byfollowing a strategic – based platform suggested by numerousresearches (Balachandran and Mochandran, 2012). Firstly, the divisionshould use balanced scorecard to monitor progress towards theorganization’s strategic goals. Balachandran and Mochandran (2012)suggest that the use of management by objectives (MBO) and strategicplanning would help align goals and objectives throughout anorganisation hence the application of the two practices by thedivision is essential. Moreover, the use of program evaluation wouldhelp increase program efficiency to help cut costs. The divisionshould also seek to use business process reengineering to redesignorganizational processes and structures. Therefore the productivityand performance will be increased. Finally, the use of total qualitymanagement (TQM) can help meet customers’ demands consistently. Toput it more simply, in order to increase the division’sperformance, the ROI must be increased, too. This can be achieved byincreasing sales, reducing expenses and reducing assets.

  1. Evaluation of performance measures

Decentralisationusually gives division managers autonomy to control certain processesof the business (Klubeck, 2011 Bowhill, 2008). It involves thetransfer of the decision making from the head office to the differentdivisions. The performance of these divisions can be measured by twomajor ways residual income (RI) and return on investment (ROI) whichthey will help them control performance and increase businessprocesses.

Tobegin with, ROI is a relative performance measurewhich provides auseful summary for the return on capital employed. It expressesdivisional profit as a percentage of total assets employed in thedivision. Therefore, it can be easily understood and used forinter-division and inter-firm comparisons,which set it morepreferable than the RI (Kaplan, online). Moreover, ROI is anindication of the division’s profitability as it determines if thedivision’s earned returns on the invested capital are above thedivision’s cost of capital.

However,the fact that ROI is relative measure rather than absolute prevent itfor focusing on measuring value added. It is possible divisional ROIto be increased by actions that will worsen the company as a whole,and conversely, decreased by actions that will improve the company.As a result, managers may be motivated to make decisions that are notin the best interest of the company, known as dysfunctionaldecisions. This is because ROI mainly targets to a maximum rate ofreturn leading only toinvestmentsthat earn more than the current ROI.Divisional managers however should aim to earn more than the cost ofcapital in order to consider the company as a whole. Thus it can besaid that evaluation under ROI may not encourage goal congruence.

Onthe contrary, evaluation under RI can encourage goal congruence. Whenmanagers use RI, they are motivated to act both for their own and thecompany’s best interest. A positive RI will encourage them toinvest in projects that earn more than the cost of capital resultingin making the correct decision for the performance of the company asa whole. As it is also an absolute measure, it helps maximizing thecompany’s wealth.Moreover, RI is a flexible measure where differentcapital costs percentages can be applied to different investmentswith different risk levels. Therefore, it is obvious that RIovercomes some of the ROI’s dysfunctional consequences. But, itdoes have a limitation since it cannot be used to compare divisions’performances from companies with different sizes.

BothROI and RI have some disadvantages that prevent them from being thebest suitable performance measures. Due to the fact that they areused in a short term way, short-term performance is overemphasizedover long term. Moreover, under ROI and RI the division’sperformance is showed as a single figure only which is not consistentwith the complex nature of the modern businesses. They also do notprovide enough guidance to action since they don’t show managersthe full picture of a division’s performance (ACCA, online).

Whenwe assess a division, there are two measures of divisionalprofitability the evaluation of division’s managerial performanceand the evaluation of division’s economic performance. When thepurpose is to assess the divisional manager, only items that areunder the control of the manager should be considered, such as thecontrollable profit. It is computed by taking off all thecontrollable by the division’s manager costs, from the divisionalrevenues. Hence, it excludes costs which are attributable to thedivision and not controlled by its manager, for instance depreciationand legal staff. That’s why it can’t be used to measure thedivision’s economic performance and it is suitable to evaluatemanagerial performance based on the ability to use directlycontrolled by the division resources (Drury, 2012).

Whenthe purpose is to assess how the company performs in economy, itemsthat are not affected by the divisional manager should be considered,such as the divisional profit. To derive this profit,thenon-controllable expenses that are assignable to a division and whichwe would avoid if a division was closed are derived from thecontrollable profit. Therefore, divisional profit cannot be used toevaluate the divisional manager as it includes those costs that arenot under the manager’s control. It is a useful measure for thedivision’s economic performance instead, because by using it thecontribution made by a division to corporate the profits andoverheads are represented (Drury, 2012).

Investmentcan be defined with different ways. It can be considered as the totalassets available, the total assets employed, the working capital orthe shareholders equity. If we take the total assets at the end ofthe fiscal year, it will be misleading because the net income wasmade based on the assets owned by the company earlier. By calculatingthe average assets instead, it will be easier to determine whetherbusiness is effectively using its resources for the revenuegeneration. Average assets are the sum of the opening assets plus theclosing assets divided by 2. The opening and closing assets representthe total value of the assets at the beginning and ending of theperiod, thus you have an average picture of the wealth of yourcompany.

(d) Evaluation of Residual Income (RI)

  1. A Fixed Basic salary with no performance related bonus

ResidualIncome (RI) is the dollar amount (or some other currency) of divisionoperating profit in excess of the division’s cost of acquiringcapital to purchase operating assets. RI does not use ratio toevaluate performance, rather it uses a dollar amount (or some othercurrency). In case an investment is in a position to yield a higheroperating profit as compared to the division’s cost of acquiringcapital, managers that are evaluated using RI have anincentive not toturn down the investment. The main idea of managerial stall is see toit that RI is maximized from one period to the other. Form the firm’scalculations, it will be wise for the board of directors to acceptthe investment since from 2013 to 2014 the RI is increasing.This isbecause there is no performance related to bonus.

  1. A low fixed basic salary

RIis stated in dollars (or some other currency) rather than as a ratio.One division may have high RI simply because it has a larger assetbase, which produces higher revenues. Thus division managers shouldbe evaluated based on how effectively they increase RI from oneperiod to the next, perhaps in percentage growth, and not on howtheir RI compares to other divisions. If the division is has anegative RI, then it means that the division is not producing enoughoperating income to achieve the minimum required rate of return. Theboard can set the remuneration levels of the managers high since theRI is positive. Furthermore, there is a bonus based on company-wideand not divisions. Nevertheless, the board has to be careful not tocause damage to the entire firm in the name of increasingremuneration levels for divisions.

(e) EconomicValue Added (EVA)

  1. Calculation and differences from ROI and RI

EVAis considered to be the most recent development in measuringperformance. It can be defined as the difference between a company’scost of capital and the rate of return resulting to be the valuegenerated from the investments in a company. EVA can be calculated byincorporating accounting adjustment to the conventional divisionalprofit and then deducting the cost of capital charge on thedivisional assets Therefore, it is an extension of the residualincome measure since it combines the adjustments for deteriorationsby accounting principles, to the division’s financial performance(Drury, 2012). Those adjustments are made to the selectedconventional divisional profit measure aiming to replace historicaldata with an approximation of the economic profit and asset values.As a result, much flexible expenditure are capitalised and theircosts are spread over the periods where their benefits are expectedto be received. By that way, cost of capital becomes visible andmanagers are expected to generate sufficient income to cover it.

EVAis calculated as follows:

Economicvalue&nbspadded=Net&nbspoperating&nbspprofitafter&nbsptaxes‘adjusted’−(Percent&nbspcostof&nbspcapital&nbsp×&nbspAverage&nbspoperatingassets‘adjusted’)

Althoughthe calculation is similar to RI, adjustments are made to thefinancial information to better reflect the economic results of thedivision.There are two distinct differences in calculating EVAcompared to RI. First, operating profit is calculated net of incometaxes. Finding operating income aftertaxes simply requires deductingincome taxes from operating income. Second, adjustments are made tooperating income and average operating assets.

  1. Evaluation of its suitability for our business

EVAwas developed aiming to produce a financial measure which willencourage the management to focus on the shareholder wealth. Thus theprinciple of maximizing shareholder wealth is incorporated throughthe EVA and set it a prime example of value based management (VBM).Furthermore, the adjustments made in the calculation of EVA preventdistorted results by the accounting policies to be presented and thusEVA leads to goal congruence.

Onthe other hand, numerous adjustments are required to be made toprofit and capital employed. It cannot be used to compare divisionssince it is an absolute measure like RI.

APPENDIX1

2013

2014

Profit

87,000

129,400

Investment

616,000

677,600

ROI

=Profit/Investment

14.12%

19%

Capital charge

=Cost of capital x investment

49,280

54,208

RI

=Profit-Capital charge

37,720

75,192

Workings2013:

Totalsales= 100,000+400,000=500,000

Profit=Sales-Total costs= 500,000-413,000=87,000

Totalcosts=275,000+(275,000×40%)+(28%x100,000) = 413,000

Productioncosts proportion of total sales= (275,000/500,000) x100=55%

AverageInvestment= [1,100,000 + (1,100,000×12%)]/2= 616,000

Workings2014:

Externalsales=100,000-(100,000×20%)= 80,000

Internalsales= 400,000 + (400,000 x 45%)= 580,000

Totalsales= 580,000+80,000= 660,000

Profit=Sales – Total costs=660,000-530,600=129,400

Totalcosts= 363,000+(363,000×40%)+(80,000×28%)=530,600

Productioncosts= 660,000×55%= 363,000

AverageInvestment= [1,232,000+(1,232,000×10%)]/2 = 677,600

Thecompany has used both RI and ROI for the benefit of comparing thedivisions. Using both measures has the benefit of comparing onedivision to another by using ROI. This will reduce the conflictbetween company’s goals as well as division goals by using RI. RIis stated in dollars (or some other currency) rather than as a ratio.One division may have high RI simply because it has a largerinvestment base, which produces higher revenues. Thus divisionmanagers should be evaluated based on how effectively they increaseRI from one period to the next, perhaps in percentage growth, and noton how their RI compares to other divisions.

ROIis sometimes not liked by a number of mangers because of it can landto decisions that benefit a certain division but cause damage to theentire firm. Since this is an expanding business, ROI will not be asuitable choice to be used by managers because, insofar as there is apossibility of increasing the 19% for division, there is as well agreater possibility of reducing that percentage for the wholeorganization. All the incentives that yield less than 19% aresupposed to be shed by the division managers. To evaluate this, itwill be wise for the managers to use RI instead of ROI. This willhelp to mitigate any form of damage and conflict to the firm.

APPENDIX 1

2013

2014

Profit

87,000

129,400

Investment

616,000

677,600

ROI

=Profit/Investment

14.12%

19%

Capital charge

=Cost of capital x investment

49,280

54,208

RI

=Profit-Capital charge

37,720

75,192

Workings2013:

Totalsales= 100,000+400,000=500,000

Profit=Sales-Total costs= 500,000-413,000=87,000

Totalcosts=275,000+(275,000×40%)+(28%x100,000) = 413,000

Productioncosts proportion of total sales= (275,000/500,000) x100=55%

AverageInvestment= [1,100,000 + (1,100,000×12%)]/2= 616,000

Workings2014:

Externalsales=100,000-(100,000×20%)= 80,000

Internalsales= 400,000 + (400,000 x 45%)=580,000

Totalsales= 580,000+80,000= 660,000

Profit=Sales – Total costs=660,000-530,600=129,400

Totalcosts= 363,000+(363,000×40%)+(80,000×28%)=530,600

Productioncosts= 660,000×55%= 363,000

AverageInvestment= [1,232,000+(1,232,000×10%)]/2 = 677,600

13 | Page

Related Posts

© All Right Reserved