Case Enager Industries
- Pages: 7
- Word count: 1732
- Category: Investment
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1.0 Performance Measurement
In today’s advanced and rapidly changing manufacturing environment, operational performance measures are taking on ever-greater importance. It is due to the influences of worldwide competition, just-in-time inventory management, and an emphasis on product quality and customer service. A multidimensional conceptualization of organizational performance related predominately to stakeholders, heterogeneous product market circumstances, and time. A review of the operationalization of performance highlights the limited effectiveness of commonly accepted measurement practices in tapping this multidimensionality. Market competition for customers, inputs, and capital make organizational performance essential to the survival and success of the modern business. Marketing, operations, human resources (HR), and strategy are all ultimately judged by their contribution to organizational performance. Organizations are heterogeneous in their resources and capabilities and how and where they choose to use them. Large organizations use both financial and nonfinancial performance measures but favor financial measures. 1.1 Financial Performance Measurement
Financial performance measures give little or no guidance to future performance since they do not include any measures relating to customers’ satisfaction and organizational learning. Furthermore, Eccles and Pyburn (1992) claim that financial performance measures are oriented internally rather than externally. A performance measurement and evaluation system involves comparing actual performance with targeted performance in terms of budgets or the past period’s performance. Both of them (target and measures) are developed internally and do not consider the performance of the competitors in the same industry or the average performance within the industry. According to Johnson and Kaplan (1987), companies tend to rely on accounting-based information that is appropriate for external financial reporting but is questionable for internal performance measurement and evaluation. In brief, the traditional financial measures do not provide a complete picture relating to managerial performance. 1.2 Non-Financial Performance Measurement
Management accounting literature also advocates the use of non-financial performance measures as a tool. The benefits that can be gain from this measurement are: * Overcome the deficiencies attributed to financial measures. * Identify the forces that determine financial performance. * Necessary for operational control purposes.
* Assist and motivate management in its goal of continuous process improvement. In the intervening years, the call for a broader set of performance measures has been continuing. These measures may include measures for productivity market effectiveness, product leadership, personnel development, employees’ attitudes, market share, social responsibility, product’s development, employee turnover, raw material and scrap, machinery, productivity, innovation and learning, product quality, inventory costs, manufacturing flexibility and delivery performance. The balanced scorecard, with its lead and lag measures of performance, is one tool that is more and more widely used as a means of introducing nonfinancial measures into performance evaluation. 1.3 Profit Center
Prior to 1992, each Enager Industries, Inc division had been treated as a profit center, with annual division profit budgets negotiated between the president and the respective division general managers. Profit center is a division or subunit of a company that is accounted for on a stand-alone basis for the purposes of profit calculation. A profit center is responsible for generating its own results and earnings as well as for controlling control, and as such, its managers generally have decision-making authority related to product pricing and operating expenses. Profit centers are crucial in determining which units are the most and least profitable within an organization. The concept of profit centers enables a company’s executives and management to determine how best to focus its resources to maximize profitability. In order to optimize profits, they evaluate on contribution margin and amount of capital invested, thus management may decide to allocate more resources to highly profitable areas, while reducing allocations to less profitable or loss-making units. Not all units within an organization can be tracked as profit centers. This is especially applicable to departments that provide an essential service within an organization, but do not generate their own revenues. Some examples of these include the research department within a broker-dealer, the administration arm of a company, and a unit that provides after-sales support in an organization. 1.4 Investment Center
Since 1992, the company had decided to begin treating each division as an investment center, so as to be able to relate each division’s profit to the assets the division used to generate its profits. The shifted to the investment concept because comparing absolute differences in profit is not meaningful and difficult to compare profit performance unless assets employed is taken into account. Besides, business unit managers have two performance objectives which are to generate profits from resources used and to invest in additional resources only if it produces an adequate return. Investment center is a business unit that can utilize capital to directly contribute to a company’s profitability. Companies evaluate the performance of an investment center according to the revenues it brings in through investments in capital assets compared to the overall expenses. An investment center indirectly adds profit and is evaluated according to the money it takes to operate. Moreover, unlike a profit center, investment centers can utilize capital in order to purchase other assets. Because of this complexity, companies have to use a variety of metrics, including return on investment (ROI), residual income and economic value added (EVA) to evaluate performance. 1. Return On Investment (ROI)
The higher profit from one division to the other division in a company when the performance is evaluated based on divisional profit unable to indicate which division is performed better. The important question is not how much profit each division earned, but rather how effectively each division used its invested capital to earn a profit. This most common measurement is defined as follows: ROI=IncomeInvested Capital
The ROI is able to improve by increasing either or both of its components. Profit can be increased without changing total sales revenue by increase sales prices while selling less quantity carefully without losing sales or decrease expenses without diminish product quality, customer service, or overall store atmosphere. The alternative way of increasing ROI would be to increase its capital turnover. It’s either increase sales revenue by using store space more effectively or reduce the division’s invested capital by lowering inventories. Improving ROI is about a balancing act that requires all the skills of an effective manager. However, investment centers with old assets will show much higher ROIs than with relatively new assets. This can discourage investment center managers from investing in new equipment. If this behavioral tendency persists, a division’s assets can become obsolete, making the division uncompetitive. 2. Residual Income
Residual income is a dollar amount of an investment center’s profit that remains (as a residual) after subtracting an imputed interest charge. The divisions that have different levels of risk sometimes are assigned different imputed interest rates. Residual Income=Investment center’s profit-(Investment center’sinvested capital x Imputed interest rates) This concept should not be used to compare the performance of different-sized investment centers because it incorporates a bias in favor of the larger investment center. The higher amount of residual income of a division, the greater its invested capital as evidenced. In terms of shareholder value analysis, the residual income is calculated for a major product line, with the objective of determining how the product line affects the firm’s value to the shareholders. 3. Economic Value Added (EVA)
The most contemporary measure of investment center performance is EVA which is defined as follows: EVA = Investment center’s after tax operating income – [(Investment center’s total assets-Investment center’s current liabilities) x Weighted average cost of capital] EVA is also a dollar amount, an investment center’s current liabilities are subtracted from its total assets and the weighted average cost of capital is used in the calculation. EVA indicates how much shareholder wealth is being created. The company raises capital to make concentrate and sell it at an operating profit. Then pay the cost of capital and shareholders pocket the difference (EVA amount). In implementing the investment center concept, Randall and Hubbard decided to measure each of the division’s performance based on its return on assets, which is calculated as the division’s net income divided by its total assets. Also, Hubbard demanded that each division try to provide a return of 12% on its assets for 1992 and 1993. He also decided that all new investments must have a 15% return in order for it to be approved as the firm’s current ROA was only 9.4%. The strengths of Enager investment center concept are:
* It is able to relate each division’s profit to the assets that used to generate its profits; * Easy application and understanding: the sum of the divisional parts equal the corporate whole; * Clear goal which is each division should exceed the company’s gross return of 12%. New investment should bring 15% return to be approved. The weaknesses of Enager investment center concept are:
* Each investment center has different nature of activities and is in a different business cycle, so it has different approach and requirement to evaluate. For example, Consumer Products is in amateur market while Professional Services is in an emerging market. * Total sales are equally divided by division. More useful would be to see how much each division is actually selling. * Comparing investment centers ROA using depreciable assets is tricky. Industrial division could have a higher ROA (as mentioned) if their equipment was older (lower book-value). * Professional services should not be operating as an investment center. The manager does not make decisions regarding fixed assets. On the other hand, human capital (the people doing the services) is their main asset. * The allocation method used for corporate assets skews the results in favor of professional services division. Since professional service has fewer earnings, their allocation of assets is lower. * Profitable projects are being rejected because their ROA is lower than 15%. * The company also used ROI to measure the assets employed, it provides different incentives for investments across business units and decisions that increase a center’s ROI may decrease its overall profits.
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