Sarah McNeil, product development manager of the consumer product division, was frustrated when her new product proposal was not approved despite the project’s expected pretax earnings of $390,000. This could contribute over $0.15 earnings-per-share after taxes, which is more than the $0.10 earnings-per-share tally of 1993. ROA for the new product is 13% but it was rejected since the target for the division to hit the 12% average is for the new product to hit at least 15% ROA. The target was a result of Enager’s move to from profit center to investment center.
The move from profit center to investment center treatment on consumer products division is a good step. If the consumer product remained a profit center, it would have focused on cost and profit measurement. It wouldn’t have considered the level on investment that the division put forth. As an investment center having its own manufacturing, investments, sales and marketing, the division will be able to control and measure its investments.
Based on Enager’s current policy for new proposals, passing on the proposal’s potential means it is foregoing a big opportunity. Although the new product’s ROA is only at 13% it is still higher than the current return of the division at 10.8%.
A possible option on how the company measures economic performance can be through calculating the Economic Value Added (EVA coupled by non-financial measures to form balanced scorecard. EVA considers not only actual financial effect but also the economic value added by the investment. For an organization like the Consumer Products Division, what should a balance scorecard contain?
A good balanced scorecard for this division should cover the entire value chain. Using Porter’s value chain framework, there are specific activities through which firms create value and competitive advantage. Similar activities are employed in a manufacturing operation such as logistics, production, marketing and sales. Each perspective in the balance scorecard should contain metrics relevant and suitable to the activities of the Consumer Products Division.
Industrial Products Division
The Industrial Products division mainly makes custom-made machine tools for specific clients. As such, the process of manufacturing these tools takes several months and entails the division having a high amount of fixed assets because it needs to produce unique machines for different companies and thus have to be up to date and more flexible with their equipment. Also, each project of the industrial products division lasts for several months meaning their sales and profits require a longer time before they come in.
The recent figures show that the division has a lower ROA 6.9 compared to Consumer’s 10.8% and Professional Services’ 14.6%. This resulted in the president, Carl Randall, telling the General Manager of the Industrial Division that his division was not carrying its share of the load. The division manager had taken exception to this comment, saying the division could get a higher return “if we had a lot of old machines the way Consumer Products does.”
The industrial division’s key performance indicator is currently based on the 12% ROA target set by Hubbard. This proved to be hard to accomplish as they only managed 6.9% gross ROA.
To measure the return of investments using ROA is a big disadvantage to the industrial products division. This is because it takes longer for them to complete jobs and projects given the nature of their industry. Therefore to demand a 15% ROA on all new investments for the division is not advisable since you will only be able to see the total return of investments for this kind of a division outside of a year. From a division that is only at 6.9% ROA, they will need to increase their sales and EBIT almost without increasing their assets and investments as well. This also assumes that the division still has capacity for more workload, that their expenses can still be significantly lowered or that their pricing can be increased versus other competitors and the industry standard.
In the industry where the Industrial Division belongs, new investments are constantly needed to improve the quality of products in order to keep up with the competition, and to grow sales. Putting ROA as a measure may discourage investing in assets for growth. These considerations may account for the industrial products division’s newer machines, and as a result they are criticized for their low ROA. Inclusion of EVA in the evaluation would consider the long term impact of the investment and what value it adds to the company as a whole.
Another observation is the setting of target without any other basis for such figure. 12% might be too high to accomplish for the division given its nature. There is lack of investigation or proof that this figure is achievable in the industry.
Similar with the Consumer Products Division, other nonfinancial indicators are influential in arriving at a desired performance level. Being that all divisions contribute to total company profit, they can also be assessed on how well they grow the business. They can make investments; they can adjust their financial structure, for as long as they are achieving healthy profits. There are also other factors to consider such as customer satisfaction, given that the division produces custom-made tools after all, and the efficiency of production.
Professional Services Division
The Professional Services Division, despite being the newest of the three, has seen the highest return on assets. Although the three divisions were treated separately, when the CFO evaluated the overall performance of the company, Professional Services Division was cited as exemplary because of its high ROA compared to the other two. However, it is important to consider the significant difference of this division with the other two. The Professional Services capitalizes on the professional knowledge of the employees, an intangible resource that is not physically measured and recorded in the books. Relatively speaking, this division would indeed use less working capital compared with the other divisions in terms of the level of inputs to generate sales. Given that the sales revenues are at a similar level with the other two divisions, the Professional Services Division’s return on assets would definitely be higher upon comparison. On the other hand, its EBIT is the lowest among the divisions, probably because the salaries of the professionals, who are the core resources providing the services, are expensed.
There are three key characteristics generally attributed to “professional services.” First, organizations providing services have specialized requirements in education, training and accreditation that must be met before an individual can work in that specialty. Second, there is a high degree of self-regulation such that professionals conform to practice standards against which their ongoing work is measured. In this case, Enager ensured that their Professional Services Division leveraged on the regulatory requirement on many new land development projects with their ability to perform environmental impact studies, which will eventually gain them competitive advantage. Third, professional service providers use specialized and customized knowledge or training to provide solutions for clients. Their “deliverable” is a solution to specific clients’ problems or concerns. Professional knowledge is their core resource.
These characteristics imply the need to measure the productivity of knowledge, a measurement that is distinguished from other industries, specifically in the manufacturing industry where measures of productivity are readily quantifiable in terms of concrete input and output. Setting a financial target for the Professional Division as a gauge of their productivity and effectiveness, even if said target was reached, is not sufficient and may not necessarily be an accurate reflection of what the division actually achieved. In this case, it has high ROA surpassing the company target because the assets employed in generating profit were relatively less compared with the other division. Although ROA is indeed a performance measure appropriate to the division as an investment center, there are problems with using ROA alone to determine its performance as an economic entity, aside from the fact that the corporate office set a specific figure for ROA. As a result, there are issues in the company because of such setup, which are already mentioned in the analysis of the two preceding divisions.
While financial indicators are necessary, it is also imperative that nonfinancial indicators be included in the performance measurement of the divisions. Based on the way the divisions are evaluated, the company only rated each division on the basis of financial ratios. They made no mention of nonfinancial indicators that are also effective means of measuring division performance. Enager should consider nonfinancials such as client satisfaction, business efficiency and effectiveness, and learning and growth, because these can also influence overall financial condition.
In the case of Professional Services, non-financial indicators could include placing due importance on attracting and retaining highly-skilled resources, and delivering high-quality services to client. This is because the quality of service provided is one determinant of strong revenue and growth sales. Moreover, the performance of a service-oriented group is affected by the skill level and mix of senior and junior staff. Leveraging the expertise of its resources and continuous upgrading of skills to bring about high quality service may also serve as barrier entry for competitors, which in effect will also have impact on their market share. In terms of controlling costs, the division could do well in monitoring the average fee charged per unit of the resource time and the percentage of billable time.
Recommendation
The group maintains that the divisions be treated as investment centers because this is the best way that management can maintain control over the operations even if the divisions are distinctively different from each other. Considering that each division has different levels and types of assets employed to bring about the highest profit, some form of delegated authority from senior management must be in place for better execution of organizational strategies. Being an investment center will allow division heads to generate acceptable profits from their current resources and at the same time pursue investments that will produce an adequate return in the long run especially for the Consumer Products and Industrial divisions, both groups heavy on investments. They need to ensure that all their investments are worth taking on in order to ensure efficient performance and profitable growth.
It is pointed out that each division is independent and autonomous, implying that the division head would be able to make decisions on the spot regarding their local operations. Performance is measured mainly against its use of capital in producing profits, which entails managing their revenue and costs. However, in the matter of the management still having control despite the division’s autonomy, decisions involving long term investments in sizeable amount must be reviewed and approved at the corporate level. Such is the policy implemented that investment proposals exceeding $1.5 million must first be approved by the CFO. This policy is rightfully placed.
On the other hand, the corporate office or senior management should not prescribe a definite and exact figure for the target return on investment because this may eventually lead division heads to overemphasize the ROA at the expense of economic profit. At the same time, specifying the same ROA target for every division is inappropriate because the company is not in a single line of business and each division does not have similarly aged assets. Evaluation should also include the cost of capital since this will capture the type of assets employed by the division, which is depicted by the EVA. As capital costs increase, the return of capital employed must also increase so the division will be economically profitable. This measure also considers market value that has significant impact on their operations. Therefore, measurement should be relevant to the nature of business of each division, and the evaluation does not only focus on financial ratios.
This is where the division needs a balanced score card. The division should be measured with the nonfinancial factors and with the financial indicators. The balanced scorecard has 4 perspectives in which organizations are evaluated.
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Customer Perspective. The customer perspective will be able to motivate the division to maintain a healthy and strong relationship with clients and can bring attention to problematic actions so those will be remedied early on, before they affect key items like net income per account. Basically, this perspective aims to achieve the performance desired by the customers and how the division was able to achieve or exceed these expectations.
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Internal Business. The internal business or process perspective focuses on the internal processes that bring about the service to clients. This measure covers controls and tactical performance.
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Learning and Innovation. The learning and innovation perspective is concerned on how they are able to leverage the skills and knowledge of the main resources of the division in service or product delivery.
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Financial Perspective. This portion will contain the return on investment the shareholders put out for the business such as measuring of EVA, ROI and other indicators of financial performance.
The first three perspectives when analyzed along with the financial perspective of measuring economic profitability or the return on investment will be able to give a holistic assessment of the division’s performance.
Aside from showing the overall performance of the division, the scorecard will enable strategic planning and drive the deployment of actions required to achieve company objectives and strategies. The metrics will be able to align the behavior and initiatives of the division with the overall corporate strategy and focus on their operation and priorities.
Recommended Implementation
- The Division Head together with the Head of Human Resources will come up with a proposed list of what to measure. The senior management (management committee) will review the metrics so as to align with the general strategy and objectives of the company. Approved measures depend on what the management committee deemed to be most adequate with the company’s strategic plans and long-term goals. Typically, these are encapsulated in the company’s mission statement. Recommended metrics per division are shown in Exhibits 1 – 3.
- The scorecard may be tailored according to their discretion. The recommendation applies to the division as whole. Scorecards for each role in the division will also be established based on the scorecard of the division. The scorecard will become very specific as it goes down the organizational structure.
- Specific targets are also established in each division as appropriate and with the management committee’s approval. They must ensure that targets are realistic but at the same time, competitive against industry standards. However, it is not recommended at this point that these targets will be the final figure because they will actually need to do a pilot run of the measurement for feasibility purposes.
- Once the measures are established, the HR Head will implement a policy regarding the periodic performance evaluation of each division. They can designate a quality team tasked to monitor and control the evaluation/audit activities. They need to determine in what manner and how frequently the performance measurement data will be collected and presented. This will necessitate the Division Heads to internally manage his/her team’s performance evaluation prior to the appraisal headed by the HR Head. The Division Heads may set internal schedule for regular reporting of their unit’s constituents regarding how they are doing in each areas they decide to measure.
- It is highly recommended that the divisions initiate evaluation on the chosen areas in the scorecard for a few months, so they will be able to come up with the baseline of the performance level of each division.
- After the baselines are established, Division Heads, the HR Manager and the management committee should set goals or benchmarks for improved performance in each area. Considerations in establishing benchmarks do not necessarily have to be confined to internal operations. Input from industry standards, clients, and other non-competing firms may be factored in to ensure that all aspects are considered.
- At this point, the performance measurement system should now be in place and accomplished regularly as per policy. It is best to discuss the result of each evaluation per person involved so they will know how they performed, be guided on what they need to achieve, what improvements can be done. This will also ensure that everyone will be encouraged to work together in achieving the goals connected with the performance measurement.
- Once a goal has consistently been achieved, Division Heads or the quality team can come up with new processes or metrics to measure, since this should be a continuous process improvement.
Exhibit 1 – Metrics for the Consumer Products Division
Exhibit 2 – Metrics for the Industrial Division
Exhibit 3 – Metrics for Professional Services Division
References:
Kaplan, R. (2007). The Demise of Cost and Profit Centers. Harvard Business Publishing Newsletters from:
Reece, J. & Cool, W. (1978). Measuring Investment Center Performance. Harvard Business Review from:
Anthony, R. & Govindarajan, V. Management Control Systems 12th Edition. McGraw-Hill
Williams, S. & Nersessian, D. (2007) Overview of the Professional Service Industry and the Legal Profession.
Appendix A – Enager Income Statement
Appendix B – Enager Balance Sheet
Appendix C – Financial Data from New Product Proposal
Appendix D – Calculations of Gross Return on Assets, 1993
