Problem:
Discussion of various divisional performance measures
You are the highly trusted chief accountant of Ragwort Ltd, a manufacturer of sports equipment, and you have strong private hopes of joining the board in the next year or two in a newly created post of finance director.
Ragwort is organized into three divisions, each of which is formed as a separate subsidiary company; you have a seat on the board of each of them. The three divisions and their general manager are North-West (Christopher Perkins), Home Counties (Geoffrey Gilmore), and Eastern Counties (Morton Jackson). The group executive committee consists of the three general managers, under the chairmanship of group chairman and chief executive Thomas Ragwort. It meets monthly, and the meeting usually lasts two days.
At the end of the first day of this month's meeting Ragwort calls you to his office, and tells you that he has a problem. 'You know', he says, 'that for some time now I've been concerned about what is the best measure for us to use to compare the performance of the divisions. You know what I mean - what is the right sort of target to set for them? It's not good if I impose something without agreement, and we simply didn't manage to get it today. I'm going to re-open the discussion tomorrow, and I want a decision but first I want some advice from you.'
You ask him what has happened.
'Well', he says, 'you know that we've been working out a divisional return on investment. We find pre-tax profits for each division, after charging out group head office costs in proportion to divisional turnover. We set that against a base of written down net assets, excluding cash.
Gilmore is satisfied with that, but Perkins came up with something he called residual income - he argued that we have to make absolute profits, not just a return on investment. And then Jackson said that what we really want is growth, and that the only way to get that in the long run is to set the target as percentage sales growth.
They were obviously split, so I let it run on.
To cut a long story short, Gilmore said he could certainly accept that residual income was a better measure than looking just at growth. Jackson wouldn't accept that, and still wanted the growth measure, but he agreed with Gilmore's view that it was better to stick with our present ROI than to change to this new residual income idea.
Perkins stuck to his guns over residual income. He's smart. He told Jackson that he could see at least some merit in the growth idea, because in the end it would probably correlate with residual income. But he still thought that the ROI should be dropped. I tried a compromise approach then. I suggested that we took the measure in pairs, starting with ROI and residual income. After all, they sound pretty similar. Gilmore and Jackson voted for ROI, and only Perkins supported residual income. So I had them compare ROI with growth, thinking I was home and dry and we needn't change anything. And Perkins joined Jackson in supporting the growth idea! I had to admit that he'd said as much.
But Gilmore is pretty smart too, you know. He whispered something to Perkins. Then he reminded us that Perkins wanted us to try out residual income, and that he had already told the meeting that in his view residual income was a better control measure than percentage sales growth. So if we were going to make a change the majority obviously preferred residual income to growth.
By then, I felt that it was time to adjourn!
You'd better keep all this under your hat. But give me a short report summarizing the pros and cons of these three possibilities, and giving me your view on which one would be best in principle for us to use in future. If I eventually have to lay the law down I want to get it right. But make sure you keep it short - not more than about four pages.'
On returning to your office you cancel your previous arrangements for the evening, and then quickly work out the following table, showing the average annual performance of the divisions over the last three years in historic cost terms:
|
|
|
Residual
|
Sales
|
|
|
Division
|
Manager
|
ROI
|
income
|
growth
|
|
|
|
%
|
£
|
%
|
|
Home Counties
|
Geoffrey Gilmore
|
10
|
80000
|
15
|
|
Eastern Counties
|
Morton Jackson
|
8
|
60000
|
25
|
|
North West
|
Christopher Perkins
|
6
|
100000
|
20
|
You send a copy of the table to Mr Ragwort with a note commenting that it may help to explain the attitudes being taken in the meeting. You then settle down to think about the three measures proposed as means of controlling divisional performance.
You are required to write a report for Mr Ragwort about the proposed methods of measuring divisional performance, to comply with the terms of his instruction