Divisional Performance Measurement, Economic Value Added, Cost Accounting Help

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Divisional Performance Measurement

Performance measurement, an important concept to which all organizations regardless of size, nature or operating structure have strong concern. External investors and creditors measure performance through financial statement ratios to determine organization’s profitability. It is necessary to develop a sound basis that would help the company measure its performance. In organizations, it is necessary to evaluate the performance of managers as well as employees.

Profit Centers and Investment Centers:

Profit center is a segment of decentralized organization that has been assigned control over both i.e. how revenues are generated and how costs are incurred. A comparison of budgeted controllable income statement with that of actual controllable income statement is made in case of profit centre profit valuation. Such controllable income is calculated by deducting profit center’s controllable costs from its controllable revenues. Managers performance evaluation is mostly based on this criteria.

Investment center is also the segment of decentralized organization that has been assigned control over three factors i.e. generation of revenues, incurrence of costs and acquisition of investment center assets. These are similar to profit centers; therefore they are often also known as special cases of profit centers. Investment center manager has decision making authority for the level of physical assets and financial assets employed in the investment center. Its performance valuation should be depending on comparison of budgeted return with actual return on investment.

Advantages and Disadvantages of Divisionalization:

Decision making process can be enhanced through divisionalization i.e. both quality and speed of decision. Quality of decision is improved in a sense that via decentralization, a person making decision is fully aware of the circumstances, therefore he can make the best decision on the basis of his judgment. Improvement in speed of decision making means that quick decision takes place as information has not to cover a long chain as in case of centralization. Another advantage is that managers feel free to make decision, have power to make self-assessment decisions. Top management gets also free from day to day operations, so that they make their concentration only on the strategic planning.

One of the main disadvantages of divisionalization is that sometimes managers would make unnecessary decisions that are not fruitful to organizational goals. Managers often make such decisions that are beneficial for themselves only not for their industry. Managers not only themselves but also motivate their employees towards the goals of the entity.

Return on Investment (ROI):

It has been used for many years in banking and other financial activities for performance measurement. It is often used to make comparison between short-term projects to determine which is favorable for us. It serves as both planning technique as well as control technique. When this technique is used for performance valuation, investment center manager would be expected to produce a more return on assets as compared to the return that can be obtained from alternative use of these assets. It can provide an objective measure of investment center performance as budgeted at the beginning of the period and compared to the actual end of the period investment center performance.

Residual Income:

This principle was developed due to one of the major drawback of ROI i.e. ROI focuses to increase rate of return rather than on absolute rupees. Under this technique, performance is being evaluated by the amount of residual income rather than rate of return. Residual income can be calculated by subtracting an opportunity-type cost from controllable income. Upper management is charging an investment center manager for using those assets within his control, that were paid by company funds even though they were authorized by an investment centre manager. As a result of this, the company is implying that it can get a rate of return at least equal to minimum desired rate of return. Many companies have developed non profit measures to provide a more balanced evaluation of responsibility center performance evaluation.

Economic Value Added:

It is, nowadays, most successful performance measuring tool in growing industries. Although according to some definitions, it is similar to residual income, however, there are some technical differences between the both. EVA makes things clear from ambiguity. It has enabled industries to report profits while they are actually approaching for insolvency.

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