Divisional Performance

Question 1

Benchmarking

Answer 1

Benchmarking: Key Points

Types of Benchmarking
1. Internal Benchmarking
- Comparison within the same organization.
- Example: Comparing procurement departments of different hospitals within the same healthcare system.

2. External Functional Benchmarking
   
   • Comparing a specific function with the best performer in any industry.
   • Example: A school comparing its performance with another similar school in a different area.
3. Competitive Benchmarking
   
   • Using a competitor as a benchmark.
   • Less common in the public sector due to fewer direct competitors.
4. Out of Category Benchmarking
   
   • Comparing with organizations having different objectives or activities.
   • Example: Public sector logistics department benchmarking against a private sector international courier company.

Selecting the Benchmark
- Similar Organizations: Easier comparison and adoption of practices.
- Best in Class: Identify the top performers for the activity or process being benchmarked.

Measuring Benchmark Performance
1. Identify Measurement Needs
- Define what to measure before starting the process.
- Determine the required information.

2. Sources of Information
   
   • Public Domain: Financial reports, industry benchmarks, newspaper and analyst reports.
   • Data Sharing: Direct contact or through professional conferences, supplemented by staff interviews.

Factors Influencing Benchmarking Effectiveness
1. Learning from Benchmarks
- Benchmarking should involve learning and adopting best practices, not just measuring performance.

2. Stakeholder Pressure
   
   • Improvement often requires pressure from stakeholders, such as supervisory boards or service users.
   • Economic pressure from users choosing alternative providers based on benchmarking results.
3. Monopoly Providers
   
   • Economic pressure is ineffective where users cannot switch providers.
   • Stakeholders may misunderstand benchmarking results, leading to unrealistic pressure.
4. Dysfunctional Effects
   
   • Managers may improve measured scores without real performance improvement.
   • Benchmarking can be used defensively to explain poor performance instead of driving improvement.
5. Expert Stakeholders
   
   • Misinterpretation is less common among expert stakeholders who understand the context.

League Tables
- Purpose: Summarize performance metrics into an overall score to rank organizations.
- Benefits: Simplifies comparison and encourages competition.
- Criticisms:
- Arbitrary weighting of factors.
- Fails to account for contextual differences like demographics.

Conclusion
- Efficiency and Effectiveness: Public sector bodies use targets and benchmarking to improve performance.
- Stakeholder Influence: Successful benchmarking often depends on stakeholders’ ability to pressure organizations to improve.

Question 2

Summary: Characteristics of Performance Measures for Divisional Performance Evaluation

Answer 2

Key Characteristics of Good Performance Measures:

1. Goal Congruence:
   
   • Encourages divisional managers to make decisions aligning with the company’s overall best interests.
2. Controllability:
   
   • Managers and divisions should be evaluated based on performance aspects they can control.
   • Important to distinguish between controllable profit (manager’s performance) and traceable profit (division’s performance).
3. Long-term and Short-term Objectives:
   
   • Performance measures should recognize both long-term and short-term organizational goals.

Controllability: Distinguishing Controllable vs Non-Controllable Profit

Controllable Costs:
- Costs that the divisional manager can directly control.

Traceable Costs:
- Includes controllable costs plus other directly attributable costs not controlled by the divisional manager (e.g., head office marketing fees).

Performance Assessment:
- Manager’s Performance: Assessed using controllable profit.
- Division’s Performance: Assessed using traceable profit.

Further Distinction:
- Divisional Profit: Excludes centrally incurred overhead costs re-apportioned to divisions. Essential for comparing the division’s performance against external competitors.

Example 1: Calculating Controllable, Traceable, and Divisional Profit

Given Information:
- Revenue: $529m
- Variable Costs (controlled by divisional manager): $286m
- Fixed Costs (controlled by divisional manager): $137m
- Marketing Campaigns (controlled by head office): $28m
- Apportioned Head Office Costs: $43m

Calculations:
- Controllable Profit: $106m (Revenue - Variable Costs - Fixed Costs)
- Traceable Profit: $78m (Controllable Profit - Marketing Campaigns)
- Divisional Profit: $35m (Traceable Profit - Apportioned Head Office Costs)

Issues with Controllability

• Difficulty in distinguishing costs as entirely controllable or non-controllable.
• Revenue affected by non-controllable costs can overstate a manager’s performance.
• Potential solution: Specify budget lines as controllable or non-controllable.

Performance Measurement

Return on Investment (ROI):
- Measures operating profit as a percentage of assets employed.

Residual Income (RI):
- Measures income less a cost of capital charge on assets employed.
-

Return on Capital Employed (ROCE):
- Measures efficiency in using capital to generate profits.
- More appropriate for company-wide or external comparisons.

Example 2: Calculating ROI and RI

Scenario:
- Division B launches a new product, investing $50 million in machinery.
- Marketing department spends $14 million on a campaign for Division B.

ROI Calculation:
- Based on controllable profit and investment if evaluating the manager’s performance.

RI Calculation:
- Subtracts the imputed interest on controllable or traceable investment from the corresponding profit.

Conclusion

• Controllability ensures fair performance evaluation by focusing on aspects within a manager’s control.
• Goal Congruence aligns divisional decisions with overall company goals.
• Long-term and Short-term Objectives balance immediate and future performance goals.
• Appropriate use of ROI, RI, and ROCE depends on the context and purpose of the performance evaluation.

Question 3

Operational Gearing

Answer 3

Summary: Operational Gearing and Cost Structures

Operational Gearing Overview:
- Definition: Measures the business risk associated with how fluctuations in sales volume impact profits due to fixed costs.
- High Ratio Implication: Greater risk, as higher fixed costs mean that a drop in sales can lead to significant profit declines.
- Calculation: Defined as contribution (revenue minus variable costs) divided by operating profit (PBIT).

Freuchie’s Situation:
- Contribution vs. Operating Profit: Freuchie has a high contribution but low operating profit, indicating fixed costs are only marginally covered.
- Impact of Sales Fluctuations: A small revenue decrease can lead to losses, as seen in 20X4.

Operational Gearing Calculation:
- Budget 20X5:
- Revenue: $641.0m
- Cost of Sales: $380.5m
- Contribution: $301.3m
- Operational Gearing: 40.7

• Actual 20X5:
  
  • Revenue: $638.1m
  • Cost of Sales: $378.9m
  • Contribution: $299.9m
  • Operational Gearing: 44.8
• Actual 20X4:
  
  • Revenue: $577.7m
  • Cost of Sales: $342.1m
  • Contribution: $272.1m
  • Operational Gearing: 85.0

Cost Structure Analysis:
- Fixed Costs: Include rent, property costs, marketing, head office costs, insurance, utilities, and depreciation. These costs are associated with the number of stores but not directly with revenue per store.
- Staff Costs: Mostly fixed but include a variable bonus element which has been adjusted for in calculations.

Risk and Volatility:
- High Fixed Costs: Freuchie’s high fixed costs contribute to its operational gearing, making the business risky.
- Revenue Sensitivity: A 10.5% change in revenue from 20X4 to 20X5 moved Freuchie from a loss to a profit, demonstrating volatility and sensitivity to sales changes.

Conclusion:
Freuchie’s high operational gearing reflects its significant fixed costs, making it vulnerable to revenue fluctuations. This volatility underscores the importance of managing fixed costs and sales stability to ensure profitability.