Jenson, Lewis and Webb (JLW) manufactures tubes of acrylic paint for sale to artists and craft shops in Kayland and Seeland. JLW has two divisions, Domestic division and Export division, both based in Kayland. All costs are incurred in Kayland Dollars ($KL). Domestic division is an investment centre and sells only to customers in Kayland. Export division is a profit centre and exports all its products to Seeland, where customers are invoiced in Seeland Pounds (£SL), at prices fixed at the start of the year. The objective of JLW is to maximise shareholder wealth.
At the beginning of the year ended 31 December 2016, the head office at JLW purchased new production machinery for Export division for $KL2·5m, which significantly increased the production efficiency of the division. Managers at Domestic division were considering purchasing a similar machine, but decided to delay the purchase until the beginning of the following financial year. On 30 June 2016 the $KL weakened by 15% against the £SL, after which the exchange rate between the two currencies has remained unchanged.
The managers of the two divisions are currently appraised on the performance of their own divisions, and are awarded a large bonus if the net profit margin of their division exceeds 8% for the year. Extracts from the management accounts for the year ended 31 December 2016 for both divisions are given in Appendix 1. On being told that she would not be receiving a bonus for the financial year, the manager of Export division has commented that she has had difficulty in understanding the bonus calculations for her division as it is not based on traceable profit, which would consider only items which relate directly to the division. She also does not believe it is appropriate that the net profit margin used to appraise her performance is the same as ‘that which is used to evaluate the performance of Export division itself’. She has asked for a meeting with the directors to discuss this further.
JLW’s directors intend to award divisional managers’ bonuses on the basis of net profit margin achieved in 2016 as planned, but have asked you as a performance management consultant for your advice on the comments of the Export division manager in advance of their meeting with her. One director has also suggested that, in future, economic value added (EVATM) may be a good way to evaluate and compare the performance of the two divisions. You are asked for your advice on this too, but you have been specifically asked not to attempt a calculation of EVATM.
Appendix 1 – Extracts from management accounts for year ended 31 December 2016
Evaluate the comments of the Export division manager that the net profit margin used to appraise her own performance should be different from that used to appraise the performance of Export division itself.
A key characteristic of divisional performance measurement is that divisional managers, and the divisions themselves, should only be appraised on performance that they control. For example, costs which are not controlled by divisional managers, such as JLW’s apportioned head office costs, should be added back to profit when appraising manager’s performance.
Similarly, as Export division is a profit centre, divisional managers are not able to make capital investment decisions and so depreciation is out of their control and should be added back to profit for their appraisals. Domestic division is an investment centre, so managers there can make investment decisions, and depreciation is a cost which they can control.
On 30 June 2015, the $KL weakened by 15% against the £SL. This meant Export division benefited from an increase in revenue which was not under the control of the divisional manager. This amount must be deducted from revenue when calculating the controllable net profit for Export division.
The net profit arrived at after items which are not under managers’ control are added back is known as the ‘controllable profit’. This is what divisional managers should be appraised on. This is because it is unfair to appraise them on factors outside their control, and may mean they become demotivated or give up trying to improve performance, which is not in the interests of JLW as a whole.
Divisional performance should be evaluated on all the items which relate directly to the division which is its ‘traceable profit’. Allocated head office costs do not directly reflect the activity of the division and should be excluded when calculating the traceable profit.
The traceable net profit for Export division, after adjusting for allocated head office costs, was $KL905,000 (W1), and the traceable net profit margin was 11%.
A difficulty with calculating controllable and traceable profits in this way may be that it is difficult to determine which items are controllable or not. For example, though the new machine purchased for Export division by head office did lead to improvements in productivity, the extent of this increase must be attributed to good management, or otherwise, by the divisional managers. This increase in productivity is therefore due partly to controllable factors, and partly to uncontrollable.
Recommend, using appropriate calculations, whether the manager of Export division should receive her bonus for the year.
Conclusion on payment of Export division manager’s bonus
The controllable net profit is arrived at after items which are not under the manager’s control are added back. The net profit margin controllable by the manager of Export division is 10%. Given that it is difficult to assess the effect of the increased productivity on controllable net profit, the manager should be awarded her bonus for the year. This is because the controllable net profit margin of 10% exceeds the target of 8%.
W1 – Controllable net profit margin for Export division year ended 31 December 2016
Advise whether the use of economic value added (EVATM) is an appropriate measure of performance of the two divisions. You are not required to perform an EVATM calculation.
EVATM as a performance measure for Export and Domestic divisions
EVATM makes adjustments to the financial profit to calculate the economic value generated by each division, and then makes a deduction for the cost of the capital invested in the division. A positive EVATM indicates a division is creating value above that required by those who finance the business. It is therefore consistent with JLW’s objective to maximise shareholder wealth. Appraisal of divisional performance on this basis would therefore align the interests of managers with those of JLW’s shareholders.
EVATM involves making many adjustments to operating profit and capital employed. These may be time consuming, and be poorly understood by managers. The manager of Export division has already commented that she finds the bonus calculations difficult to understand. Failure of managers to understand the EVATM calculations would make it difficult for them to work towards targets set for the division.
EVATM avoids distortion from estimates and financial policies
EVATM avoids the financial results from being distorted by accounting policies and estimates made by divisional managers, for example, the $KL75,000 bad debt provision made in Domestic division, as increases in provisions are added back to operating profit in the EVATM calculation. Whilst this provides a consistent basis to evaluate performance of divisions within JLW, EVATM is not suitable for comparing divisional performance as it is an absolute measure and does not make allowance for their relative sizes.
EVATM encourages managers to take a long-term view
The advertising costs for the new range of paints would be capitalised as these generate future value. The use of EVATM would encourage managers to incur costs, such as these, which will benefit the business in the long term.
However, the calculation of EVATM is backwards looking, and based on historical financial information, whereas shareholders need information about future performance on which to base their decisions.
EVATM takes into account the cost of capital
The current performance measure of net profit margin is a poor measure as it takes into account neither the absolute net profit achieved, the capital employed in the division, nor the cost of capital. By making a deduction for the cost of capital employed in the division, the EVATM calculation makes managers consider both the capital employed and the cost of capital in their divisions.
Export division is a profit centre and managers do not have control of investment decisions and hence it is not a suitable measure for the evaluation of the performance on Export division because there is no controllable capital employed. Domestic division is able to control investment decisions, and does have controllable capital employed, so EVATM would be a suitable measure for evaluating Domestic division’s performance.
However, to use the weighted average cost of capital (WACC) in the EVATM calculation requires a number of assumptions and estimates to be made, for example, in calculating the cost of equity or market value of debt. The WACC is normally based on historic data, which may not reflect circumstances in the future, and may not be accurate.