What is the difference between controllable and traceable return on investment

In a divisional organisation, head office management needs to evaluate the performance of its divisions. This article discusses three measures which could be used to measure divisional financial performance — Return on investment ROI , residual investment RI and economic value added EVA TM — and assesses the advantages and disadvantages of each. The article also discusses the importance of distinguishing between divisional performance and managerial performance.

Many large organisations have divisionalised structures. In this context, it is important to recognise the distinction between divisional performance and managerial performance. Another key question relates to the choice of measure or measures which are used to assess performance; in particular, return on investment ROI , residual income RI or economic value added EVA TM. This article will focus on financial performance measures: how different measures are used to assess performance, and the advantages and disadvantages of the different measures.

However, if an organisation focuses only on financial measures this be an underlying disadvantage because it overlooks the non-financial factors — market position, productivity, quality, and innovation — which could contribute to its longer-term success. You should already be familiar with the characteristics of good divisional performance measures from your studies of Performance Management at Applied Skills:.

The issue of goal congruence, in particular, will be important in relation to the advantages and disadvantages of the different methods. But first the importance of controllability when assessing what aspects of performance are measured will be considered.

The issue of controllability is key to this: managers should only be assessed in relation to aspects of performance they can control, whereas a division should be assessed in relation to its overall performance. In turn, the importance of controllability highlights the need to distinguish between controllable and traceable costs, and therefore controllable and traceable profit.

Controllable costs are those which are controllable by the manager of the division. Expenditure relating specifically to the division but agreed by head office — not by the divisional manager — should be treated as traceable costs, not controllable ones. For example, marketing fees relating to the division but agreed by the Head Office marketing director not the divisional manager are traceable, not controllable. Similarly, legal fees or audit fees relating to the division but agreed by head office.

However, there is a further distinction to recognise: that between traceable and divisional profit:. Traceable profit should exclude overhead costs which are incurred centrally and then re-apportioned to a division. These costs are provided by head office for the benefit of multiple divisions, rather than relating directly to one division eg central marketing services, HR, IT or finance. Recognising the share of head office costs is important though in order to reflect the costs the division would have to incur if it were independent.

If divisional performance is assessed on only traceable profit it is likely to be overstated compared to an external competitor. If the division were a separate company, it would have to incur some of the corporate costs itself for example, HR, IT, finance costs, which are incurred by head office within a group structure.

As such, a company should use divisional profit to compare the performance of one of its divisions to that of an external company. Based on this information, calculate controllable, traceable and divisional profit for the last year:.

However, a manager could take action to reduce the adverse impacts of a price change by trying to substitute alternative materials.

One potential solution to the issue of classifying controllable and non-controllable factors is to specify which budget lines are to be regarded as controllable and which are not. However, perhaps an even more important consideration for corporate management is which performance measures they use in order to make that assessment.

Two commonly used measures of divisional performance are return on investment ROI and residual income RI. The performance of a manager is indicated by the controllable profit and the success of the division as a whole is judged on the traceable profit.

Controllable costs and revenues are those costs and revenues which result from decisions within the authority of a particular manager within the organisation. For example, depreciation on machinery in Division A is a traceable fixed cost because profit centre managers do not have control over the investment in non-current assets. In addition because RI uses the cost of capital to calculate an imputed interest this cost of capital can be adjusted to recognise the risk in different projects.

Example 2: PQR plc is considering opening a new division to manage a new investment project. Forecast cash flows of the new project are as follows:. Required: Calculate the project's net present value and its projected ROI and residual income over its five-year life. Commentary : This example demonstrates two points. Firstly, it illustrates the potential conflict between NPV and the two divisional performance measures.

This project has a positive NPV and should increase shareholder wealth. However, the poor ROI and residual income figures in the first year could lead managers to reject the project. Secondly, it shows the tendency for both ROI and residual income to improve over time.

Despite constant annual cash flows, both measures improve over time as the net book value of assets falls. This could encourage managers to retain outdated assets. In recent years, the trend in performance measurement has been towards a broader view of performance, covering both financial and non-financial indicators.

The most well-known of these approaches is the balanced scorecard proposed by Kaplan and Norton. This approach attempts to overcome the following weaknesses of traditional performance measures:. Single factor measures such as ROI and residual income are unlikely to give a full picture of divisional performance. The balanced scorecard approach involves measuring performance under four different perspectives, as follows:.

The term 'balanced' is used because managerial performance is assessed under all four headings. Each organisation has to decide which performance measures to use under each heading.

Areas to measure should relate to an organisation's critical success factors. Critical success factors CSFs are performance requirements which are fundamental to an organisation's success for example innovation in a consumer electronics company and can usually be identified from an organisation's mission statement, objectives and strategy. Key performance indicators KPIs are measurements of achievement of the chosen critical success factors.

Key performance indicators should be:. Example 3 demonstrates a balanced scorecard approach to performance measurement in a fictitious private sector college training ACCA students.

The main difficulty with the balanced scorecard approach is setting standards for each of the KPIs. This can prove difficult where the organisation has no previous experience of performance measurement. Benchmarking with other organisations is a possible solution to this problem. Allowing for trade-offs between KPIs can also be problematic.

How should the organisation judge the manager who has improved in every area apart from, say, financial performance? One solution to this problem is to require managers to improve in all areas, and not allow trade-offs between the different measures.

Decentralisation and the need for performance measurement. TABLE 1. What makes a good performance measure? A good performance measure should: provide incentive to the divisional manager to make decisions which are in the best interests of the overall company goal congruence only include factors for which the manager division can be held accountable recognise the long-term objectives as well as short-term objectives of the organisation.

Traditional performance indicators Cost centres Standard costing variance analysis is commonly used in the measurement of cost centre performance. TABLE 2.