Applying the Controllability Principle and Measuring Divisional ...
<ul><li><p>Applying the controllability principle andmeasuring divisional performance in UK companies</p><p>Research Executive Summaries Series</p><p>Vol. 1, No. 8</p><p>byProf. C Drury, Huddersfield UniversityH EL-shishini, Huddersfield University</p><p>ISSN 1744 - 7038 (online) </p><p>ISSN 1744 - 702X (print)</p></li><li><p>Applying the controllability principle and measuring divisional performance in UK companies</p><p>Aim of this executive summaryThis executive summary aims to provide a summary for practitioners of the authorsCIMA-funded research project published as a research report under the title Divisional performance measurement:An Examination of the Potential ExplanatoryFactors.</p><p>Key issues underlying the research projectThe key issue underlying the research project is whether or not divisional managersare held accountable for items which they cannot influence by their actions. Theconventional wisdom of management accounting, as reflected in textbooks,advocates the application of the controllability principle, which is that theevaluation of a managers performance should be based only on those factors thatare under a managers control. The application of the controllability principle todivisional performance measurement results in the need to distinguish between theeconomic performance of divisions and the performance of divisional managers. It isadvocated that different performance measures should be used to evaluate theeconomic performance of the divisions and the performance of divisional managers.A separate divisional managerial performance measure applies the controllabilityprinciple by excluding those costs that cannot be controlled or influenced by adivisional manager whereas divisional economic measures generally include theallocation of uncontrollable costs based on the principle that, if the divisions wereindependent companies, they would have to bear such costs.</p><p>The limited empirical evidence, however, suggests that the allocation ofuncontrollable costs for evaluation of managerial performance is widespread andthat the controllability principle often does not appear to be applied in practice. It isapparent that the traditional two-fold classification of costs as being controllable ornon-controllable is too simplistic and that the application of the controllabilityprinciple lies along a continuum.At one extreme there is no application of thecontrollability principle with companies holding managers responsible for alluncontrollable factors.At the other extreme there is the full application of thecontrollability principle where companies tend to hold divisional managersresponsible only for controllable factors. In between these extremes managers maybe held accountable for some uncontrollable factors and not others.</p><p>The choice of appropriate measures of divisional managerial performance has beenwidely debated in the management accounting literature. One area of debate is theextent to which the controllability principle should be applied. Should differentperformance measures be used to evaluate the performance of divisional managersand the economic performance of the divisions or should a single measure be used forboth purposes? Another area of debate relates to the choice of appropriateperformance measures. The debate was concerned with which traditional financialmeasures (e.g. net profit before or after taxes, controllable profit, residual income,return on investment) should be used. Over the past decade new measures haveemerged such as economic value added (EVA) and the balanced scorecard.Non-financial measures have also been given more prominence and the relativeemphasis that should be given to financial and non-financial measures, and how theyshould be integrated, have been subject to debate.</p><p>Executive Summary</p><p>2</p><p>A copy of the full report isavailable for download fromthe CIMA website;www.cimaglobal.com</p></li><li><p>Applying the controllability principle and measuring divisional performance in UK companies3</p><p>In view of these developments, and the fact that most of theprevious empirical research was undertaken over 20 years agowhen the business environment and management practiceswere very different from those existing today, it wasconsidered appropriate to undertake empirical researchrelating to of the application of the controllability principleand divisional performance measurement in UK companies.</p><p>Aims of the research projectThe aims of the research project were therefore as follows: to investigate how far financial and non-financial measures</p><p>are used in practice to evaluate the performance of divisionalmanagers;</p><p> to identify the extent that the controllability principle isapplied to factors that are identified as uncontrollable;</p><p> to identify the influence of level of application of thecontrollability principle on the degree of satisfaction withthe divisional performance measurement system; and</p><p> to investigate the relationship between the use of non-financial measures and the degree of satisfaction withthe performance measurement system.</p><p>Content of the research reportA large part of the research report describes the growth andimportance of divisionalised structures (not summarisedfurther here), the different financial measures that are used inpractice to evaluate divisional performance and the differentcategories of uncontrollable costs. It then describes, presentsand analyses the research findings.</p><p>Conduct of the research projectThe research project involved analysing the results of 124usable returned completed postal questionnaires frommanufacturing companies with an annual turnover over 100million. The analysis was based on annual sales turnover anddivisionalised structures (including listed and unlistedcompanies and subsidiaries or divisions of overseascompanies).The respondents were located in finance sections,at head office and in divisions.</p><p>Background to the researchTo understand why the research project focused on thespecified objectives it is appropriate to look at some of theunderlying information contained in the report.</p><p>Divisional performance measuresThe report addresses how divisional performance can bemeasured.</p><p>Distinguishing between economic and managerialdivisional performanceCorporate management require performance measures toassist in evaluating the economic performance of a division asa whole and its economic viability and future direction.Divisional profit in this case usually, but not always, includes allallocated central costs. In addition, measures are required toevaluate the performance of divisional managers. Forevaluating managerial performance conventional wisdomadvocates that performance evaluation should be limited tothe profit that is controllable or at least influenced by thatmanagers actions. Examples of costs that would be excludedfrom controllable profit include foreign exchange ratefluctuations and allocated central administrative expenses.</p><p>The measure traditionally used to measure divisionalperformance has been return on investment (ROI), whichmeasures divisional profit against the level of investment inassets attributable to a division. However, if ROI is used toevaluate managerial divisional performance it can lead to sub-optimal decisions. For example, divisional managers maybe incorrectly motivated not to undertake a project with areturn in excess of the cost of capital simply because it has alower projected ROI than the current ROI for the division as awhole.To help overcome this problem conventional wisdomadvocated the use of controllable residual income (RI), whichis controllable profit less a charge for the cost of capitalemployed. Previous empirical studies, however, suggest that RIdoes not appear to be widely used in practice.</p></li><li><p>Limitations of financial performance measures The historical limitations of financial performance measurescan be summarised as follows: they focus on short-term periods and encourage </p><p>short-termism; they are lagging indicators, evaluating the outcomes of</p><p>management actions after a time period. Therefore it isdifficult to establish a relationship between managersactions and reported financial results;</p><p> they deal only with the current period, not the future; and they use financial accounting information based on the</p><p>historical cost concept and thus tend to be poor estimates ofeconomic performance.</p><p>Given that the problems associated with the use of financialperformance measures, two possible methods of dealing withthem emerged in the early 1990s.The first (economic valueadded) seeks to improve financial performance measures andthe second (the balanced scorecard) incorporates non-financial performance measures with financialperformance measures.</p><p>Economic value added (EVA)During the early 1990s Stern Stewart and Co., a New York-based consulting firm, repackaged and refined residualincome in the form of economic value added (EVA).Theobjective of EVA is to develop a performance measure thataccounts for the ways in which corporate value can be addedor lost.Thus, by linking divisional performance to EVAmanagers are motivated to focus on increasing shareholdervalue.The EVA concept extends the traditional residual incomemeasure by incorporating adjustments to the divisionalfinancial performance measure for distortions introduced byGAAP.</p><p>EVA can be defined as:</p><p>EVA = Conventional divisional profit accountingadjustments - cost of capital charge on divisional assets</p><p>Adjustments are made to the chosen conventional divisionalprofit measure (e.g. controllable profit, net income) in order toreplace historic accounting data with a measure thatapproximates economic profit and asset values.Theseadjustments result in the capitalisation of many discretionaryexpenditures (e.g. research and development, marketing andadvertising) by spreading these costs over the periods in whichthe benefits are received.</p><p>Also by taking into account all the capital costs, economicvalued added attempts to show the amount of wealth abusiness created or destroyed in each period.</p><p>The balanced scorecardNon-financial measures, such as of competitiveness, productleadership, productivity, quality, delivery performance,innovation and flexibility have long been advocated as afurther way to prevent short-termism. Historicallyincorporating non-financial measures have presented twoproblems: there are too many of them; and they often tend to conflict with each other</p><p>The balanced scorecard, developed by Kaplan and Norton,seeks to integrate financial and non-financial performancemeasures and identify key ones that link to strategy. Measuresare developed based on four perspectives that seek to answerfour questions:</p><p>The balanced scorecard involves establishing major objectivesfor each of the four perspectives, translating each objectiveinto targeted performance measures and comparing actualperformance measures with the target measures.A criticalassumption of the balanced scorecard is that eachperformance measure is part of a cause-and-effectrelationship involving a linkage from strategy formulation tofinancial outcomes.</p><p>The balanced scorecard thus consists of two types ofperformance measures. The first consists of lagging measures.These are the financial (outcome) measures within thefinancial perspective that are the results of past actions. Theyshow the financial impact of the decisions as their impactmaterialises and this can be long after the decisions weremade. The second are leading measures that are the drivers offuture financial performance. These are the non-financialmeasures relating to the customer, internal business processand learning and growth perspectives.</p><p>Applying the controllability principle and measuring divisional performance in UK companies 4</p><p>Perspective</p><p>Customer</p><p>Internal businessprocesses</p><p>Learning and growth</p><p>Financial</p><p>Question</p><p>How do our customers see us?</p><p>What must we excel at?</p><p>Can we continue to improve and createvalue?</p><p>How do we look to our shareholders?</p></li><li><p>Applying the controllability principle and measuring divisional performance in UK companies5</p><p>Controllability and cost allocationsThe report addresses what is meant by controllability,uncontrollable factors and non-controllable costs, and whythese latter might be allocated when evaluating divisionalmanagerial divisional performance.</p><p>The controllability principle and non-controllable factorsThe controllability principle states that:managers should be held accountable only for the results thatthey can significantly influence.</p><p>This suggests there is a need to distinguish betweencontrollable and uncontrollable factors. Uncontrollablefactors can be classified into the following categories: economic and competitive factors, to which managers have</p><p>to react; acts of nature, which are beyond management control; costs that are uncontrollable by divisional managers such as</p><p>group head office general and administrative costs, taxes,interest and corporate costs; and</p><p> divisional interdependencies whereby the actions ofdivisions impact on each other.</p><p>While the effects of acts of nature tend to be treated asuncontrollable, the treatment of the remaining factors variesin practice.</p><p>Distinguishing between controllable and uncontrollablecostsApplying the controllability principle is not an easy taskbecause control typically lies along a continuum with twoextremes: full control and no control; and in between there aredifferent degrees of control.Conventional wisdom provides thefollowing guidance for distinguishing between controllableand uncontrollable items:</p><p>1. If a manager can control the quantity and price paid for aservice then the manager is responsible for all theexpenditure incurred for the services and the expenditure isfully controllable.</p><p>2. If the manager can control the quantity of the service butnot the price paid for the service then the costs are partiallycontrollable and only that amount of difference betweenactual and budgeted expenditure that is due to usage shouldbe identified with the manager.</p><p>3. If the manager cannot control either the quantity or theprice paid for the services then the expenditure isuncontrollable and should not be identified with themanager.</p><p>A more simplistic general guideline is to Hold managersaccountable for the performance areas you want them to payattention to.</p><p>Various approaches can be used to apply the controllabilityprinciple. Divisional managerial performance can be evaluatedby comparing actual performance against budget culminatingwith a bottom line that represents the chosen divisional profitmeasure (e.g. controllable profit, net income, EVA).Controllability is imposed by making managers accountablefor the variance between actual and budgeted outcomes.Uncontrollability can be fully recognised by excluding non-controllable items from the performance report orpartially recognised by ensuring that the manager is not madeaccountable for the variance by assigning budgeted costsinstead of actual costs. In the former situation the divisionaltarget and actual profit measure is not reduced whereas thelatter results in divisional profit being reduced by the bu...</p></li></ul>