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Learning Objectives By the end of this module you should understand: 1. The reasons for divisionalization 2. The advantages and shortcomings of divisionalization 3. The types of divisional structures 4. The role of return on investment and the difficulties in measuring both return and investmentinvestment 5. The weaknesses of ROI: − how residual income is calculated and the differences between RI and ROI; − how well-managed companies have a wide variety of performance measures; − the role of transfer pricing in divisionalized companies and the difficulties inherent in selecting suitable bases. Omar El-Kheshen – omar@arabacademy.com 2
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Agenda 14.1 Introduction 14.2 Why Divisionalize? 14.3 Types of Divisions 14.4 Defining Profits and Investments 14.5 Asset Base Valuation 14.6 Residual Income: An Alternative to ROI 14.7 The Imputed Rate of Interest Does Matter! 14.8 A Cautionary Note about Performance Measures14.8 A Cautionary Note about Performance Measures 14.9 Transfer Pricing 14.10 Criteria for Establishing a Transfer Price 14.11 The International Dimension Review Questions Case Studies Omar El-Kheshen – omar@arabacademy.com 3
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In this module, we’ll study costing for companies whose activities are sufficiently diverse to the extent that it leads to separating divisions Previous Modules This Module Accounting for Accounting for Individual Products or Divisions Activities Focuses on the individualFocuses on the individual Focuses on the activities ofFocuses on the activities of products or processesproducts or processes whole divisionswhole divisions We will turn our attention to the accounting issues surrounding internal transfers of goods and services in organizations Omar El-Kheshen – omar@arabacademy.com 4
第 5 页
Take MBA as an example of a divisionalized company From its 20x2 Annual Report (see (Appendix 5.1) we can see that its operations are structured around two principal sectors: 1. Industrial operations 2. Financial operations A wide spectrum of research and manufacturing activity is conducted all over the world and reported in the Annual Report (not reproduced in Appendix 5.1) in four major blocks, United Kingdom, Rest of Europe, The Americas and Africa, Asia and Australasia. Our interest lies in the problems which arise when one division of a company sells products tointerest lies in the problems which arise when one division of a company sells products to another division of the same company instead of to outside customers. Do the same prices apply? Can the selling division be allowed to make a profit from the transaction? What would happen if the buying division could source the product from an external supplier more cheaply? Additionally we will consider how to evaluate the overall performance of individual divisions. Can we use the same procedures for evaluating divisions as we use for entire companies? A division is sometimes a wholly owned company; where we also apply the same principles Omar El-Kheshen – omar@arabacademy.com 5
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Agenda 14.1 Introduction 14.2 Why Divisionalize? 14.3 Types of Divisions 14.4 Defining Profits and Investments 14.5 Asset Base Valuation 14.6 Residual Income: An Alternative to ROI 14.7 The Imputed Rate of Interest Does Matter! 14.8 A Cautionary Note about Performance Measures14.8 A Cautionary Note about Performance Measures 14.9 Transfer Pricing 14.10 Criteria for Establishing a Transfer Price 14.11 The International Dimension Review Questions Case Studies Omar El-Kheshen – omar@arabacademy.com 6
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Businesses grow in two ways, organically or through acquisition Organic Growth Growth Through Acquisitions Driven by more and more sales of more and Acquisitions are financed either by own more products cash, borrowed cash or issue of own shares The increasing cash flow and profits are By retaining the management of the invested in more productive capacity enterprise bought, they ‘learn the business’ and eventually add value to its operations Growth is usually slow Growth is quick The risks attached are Growth into areas in which relatively small the company is less certain Due to the detailed knowledge possessed by the company in the areas earmarked for expansion The two forms of growth are not mutually exclusive Omar El-Kheshen – omar@arabacademy.com 7
第 8 页
Whichever form of growth a company chooses, it is faced with managerial problems of control Reasons Behind This: Sheer Size Complexity of Operations Prevent the head office management team from exercising a sufficiently rigorous scrutiny of day- toto--day operationsday operations therefore: These operations must be separated from the other parts of the company and given their own management team Such Separation => Divisionalization Omar El-Kheshen – omar@arabacademy.com 8
第 9 页
Divisionalization has many advantages and few disadvantages that are claimed here Advantages Sharper Career Specialization Size Motivation Decisions Mobility The sheer Even in one- A feeling of Were problems Divisions provide a complexity of product ‘ownership’ and arise, local testing ground for MBA’s group companies, the pride can be solutions can be managerial talent activities makes magnitude of the engendered for sought and as it allows the the point ratherthe point rather problemsproblems the benefit of thethe benefit of the implemented soimplemented so headquarters teamheadquarters team clearly for confronting whole company by much more quickly to be drawn from specialized management may a divisionalized than if the HQ staff the best available management in be so great that it structure where had to review the managerial talent, different parts of makes sense to individual divisions matter, consult a divisional the company separate the are instructed to with the local structure is activities into treat themselves manager, make the advantageous divisions, either on like companies decision and a geographical operating on their communicate the basis or a own account and decision to the customer basis be judged local team according to their own performance Omar El-Kheshen – omar@arabacademy.com 9
第 10 页
Divisionalization has many advantages and few disadvantages that are claimed here Disadvantages Lack of Control Cost Internal Rivalries Once a division has been set up Divisionalization is seen to cost If divisions are set up with a and its management team more money; as once a division performance measurement given the task of ‘running it, is set up to be, in effect, a system which can highlight headquarters has lost a company on its own, it will superior managerial measure of controlmeasure of control require support services suchrequire support services such performance, a spirit ofperformance, a spirit of as personnel, training, competition and internal computing, perhaps R&D rivalry may be created which is This is overcome by designing a dysfunctional to the overall structure for reporting and objectives of the company discussion which allows Some companies cut headquarters to maintain headquarters’ overheads on control over the major the basis that a significantly decisions while encouraging reduced set of services will be local management to run the expected from HQ now that routine operations the divisions have their own support Omar El-Kheshen – omar@arabacademy.com 10
第 11 页
Example for how internal rivalries take place in a company It could purchase this component from Division Complains: an external supplier more cheaply than B the price at which A is selling it Division That is A sold to: A question arises: Outside Should B be allowed to buy outside even Makes components Customers for salefor sale though the variable costs for A to make the component are less than the outsidethe component are less than the outside price? From Division B’s point of view, the external price is the better one; from the company’s point of view the internal cost is the better Omar El-Kheshen – omar@arabacademy.com 11
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Agenda 14.1 Introduction 14.2 Why Divisionalize? 14.3 Types of Divisions 14.4 Defining Profits and Investments 14.5 Asset Base Valuation 14.6 Residual Income: An Alternative to ROI 14.7 The Imputed Rate of Interest Does Matter! 14.8 A Cautionary Note about Performance Measures14.8 A Cautionary Note about Performance Measures 14.9 Transfer Pricing 14.10 Criteria for Establishing a Transfer Price 14.11 The International Dimension Review Questions Case Studies Omar El-Kheshen – omar@arabacademy.com 12
第 13 页
Businesses may divisionalize on the basis of sales territories, product lines, production plants, retail outlets, customer layers or any identifiable segment of business Four main groupings can be identified from the accounting stance: Cost Centers Revenue centers Profit Centers Investment centers Divisions are heldDivisions are held Divisions are givenDivisions are given Costs and revenuesCosts and revenues Divisions’ netDivisions’ net responsible only forresponsible only for the task ofthe task of are matched andare matched and assets are takenassets are taken the incurrence ofthe incurrence of generating fundsgenerating funds divisionaldivisional into account wheninto account when cost and havecost and have without anywithout any performance isperformance is evaluating profitevaluating profit nothing to do withnothing to do withnothing to do withnothing to do with reference to thereference to thereference to thereference to the assessed onassessed onassessed onassessed on performanceperformanceperformanceperformance the generation ofthe generation of underlying costs orunderlying costs or bottom-line profitbottom-line profit associatedassociated disposition of thosedisposition of those in the conventionalin the conventional revenuesrevenues fundsfunds mannermanner Government- Sales division of a All divisions are All divisions are funded research shipping company applicable applicable Exampleslaboratory Omar El-Kheshen – omar@arabacademy.com 13
第 14 页
Investment centers allow corporate headquarters to assess not only the profitability of each division but also the efficiency with which assets are employed by the divisions Example: Division A may report a profit of €10 million and Division B, €8 million The conclusion that A is a more profitable division than B may have to be changed when the investment in net assets is considered alongside profit Omar El-Kheshen – omar@arabacademy.com 14
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Our interest in this module will be concentrated on investment centers Divisional Managers Are evaluated on both: Their profit and Their net assets loss account base It should not be inferred from the term ‘investment centre’ that the divisional management has unfettered freedom over investment in assets Corporate headquarters will have to approve (and perhaps provide the funds for) investment proposals over a predetermined threshold Omar El-Kheshen – omar@arabacademy.com 15
第 16 页
Agenda 14.1 Introduction 14.2 Why Divisionalize? 14.3 Types of Divisions 14.4 Defining Profits and Investments 14.5 Asset Base Valuation 14.6 Residual Income: An Alternative to ROI 14.7 The Imputed Rate of Interest Does Matter! 14.8 A Cautionary Note about Performance Measures14.8 A Cautionary Note about Performance Measures 14.9 Transfer Pricing 14.10 Criteria for Establishing a Transfer Price 14.11 The International Dimension Review Questions Case Studies Omar El-Kheshen – omar@arabacademy.com 16
第 17 页
There are two aims for divisional accounting systems Decision-MakingDecision-Making Performance MeasurementPerformance Measurement Providing informationProviding information Allow the performance of itsAllow the performance of its relevant to the managers forrelevant to the managers for management to be measuredmanagement to be measured decision makingdecision makingdecision makingdecision making This leads to: Only those revenues, costs and net assets under the control of the divisional manager should be included in the calculations Omar El-Kheshen – omar@arabacademy.com 17
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Consider the following divisional profit and loss account; note the share of costs incurred by the headquarters on behalf of all divisions 1 2 3 4 5 The traditional accounting profit of €1250 arises after deducting all costs (incurred and HQ- allocated) from revenue. But is it fair to hold the divisional manager responsible for all of these HQ-allocated charges? Omar El-Kheshen – omar@arabacademy.com 18
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This divisional share of HQ costs are considered by the divisional managers as non- controllable Examples of Non-Controllable CostsExamples of Non-Controllable Costs Sales andSales and R&DR&D PersonnelPersonnel Depreciation onDepreciation on Lease CorporateLease Corporate MarketingMarketing ComputerComputer AircraftAircraft Brand awareness R&D facility that HQ personnel Charge made by Executive jet advertising and undertakes more and training staff HQ to cover the kept for the TV commercials, basic research used by each cost of salary exclusive use of from which allfrom which all than thatthan that divisiondivision preparation forpreparation for the chairman onthe chairman on trading divisions undertaken at all staff including both company benefit but the divisional divisional staff and domestic which cannot be level which and to handle visits afforded by any tends to focus production division on development scheduling individually work issues arising at divisions It is advantageous to strip out from the divisional profit and loss account costs which were imposed on a division by corporate headquarters Omar El-Kheshen – omar@arabacademy.com 19
第 20 页
Here, in our case we will consider each one of these costs… Non-Controllable CostsNon-Controllable Costs Sales andSales and R&DR&D PersonnelPersonnel Depreciation onDepreciation on Lease CorporateLease Corporate MarketingMarketing ComputerComputer AircraftAircraft Division XYZ’s Divisional R&D The cost shown Division XYZ has In the year to 30 management personnel have in the P/L recently September 20x4, argues that of its little input into account arose purchased a the chairman did €€99 million sales,million sales, the selection ofthe selection of from thefrom the software programsoftware program not visit Divisionnot visit Division only 10% refers programs and vacancies filled to handle all XYZ to domestic recruitment of during the year aspects of products scientific staff and training production covered by the course spaces scheduling and its brand awareness taken by the salary payroll is campaign division compiled on site as well. No divisional use is made of the computer Omar El-Kheshen – omar@arabacademy.com 20
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