2 motivate profit performance 3 motivate appropriate

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2.Motivate “profit performance”.3.Motivateappropriate investment decisionsandefficiency in asset use.2Financial performance measures3The manager makes “operating decisions”-Choice of products, inputs, prices, customers,advertising, etc.-But not:“Investment decisions” (how muchcapital should be invested in the division).These operating decisions impact onrevenuesandoperating costs.BU designated as profit centre, and managerevaluated on “profit performance” (actual vs.budget).45Sales to external customers€XXXAdd: Transfers to other divisions€XXXTotal sales revenue-------€XXXLess: Variable costs(€XXX)SHORT RUN CONTRIBUTION MARGIN€XXXLess: Controllable fixed costs(€XXX)CONTROLLABLE CONTRIBUTION€XXXLess: Non-controllable avoidable costs(€XXX)DIVISIONAL CONTRIBUTION€XXXLess: Allocated headquartersexpenses(€XXX)DIVISIONAL NET PROFIT (BEFORE TAX)€XXXControllable contributionis the most appropriate measureof adivision manager’s controllable performance(shouldbe measured and reported relative to budget).Divisional contributionanddivisional net profit before taxare important indicators ofeconomic performance:1.Divisional contributionIndicator of incremental contribution(contribution lost if BU is shut down).2.Net profit before taxIndicator of long-term contribution tocorporate profit (e.g., HQ may adjust its capacity downwards if BUsare discontinued).6123456197
AY321_2019-2020_HANDOUT_5_32Financial performance measures7The manager makesoperating decisionsandinvestment decisions.Therefore, evaluation ofprofitperformancealone would not be a complete evaluation ofperformance.Three possible financial performance measures:1.Return on Investment (ROI).2.Residual Income.3.Economic Value Added (EVATM).8ROI measures profits as a percentage of thecapital invested in the division.ROI =Accounting Profit/InvestmentWhere: Investment= Fixed Assets + Net Working Capital9“Absolute measure” (€, not %).Accounting profit,less a “finance charge” for the cost ofthe capital investment.Accounting profit€XXXLess: Finance charge= (Cost of capital * Investment in the division)(€XXX)Residual Income€XXX10EVATMis a version of Residual Income trademarked byconsulting firm Stern Stewart.“Adjustments” are made toovercome conservative bias inaccounting figuresand tobetter approximate economicvalues.EVATM= Net OperatingProfitAfter Tax (NOPAT)± Accounting Adjustments- {Cost of capital * “Adjusted” Investment}11Decisions on fixed asset acquisitions (managerreceives delegated authority, subject to limits).Throughoperating decisions, the managermay affect the BU’s level of working capitalinvestment(especially inventory and debtors).In practice most profit centre managersinfluence the level of investment (directly orindirectly) and should therefore be evaluated asinvestment centres.

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Term
Winter
Professor
Melissa O'Hea

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