The Effectiveness of Divisional Performance Measurement Models

1. Introduction

Nowadays, the management of multinational companies is under a great pressure to enhance divisional performance. In this context, the divisional manager’s performance is often evaluated based on financial measures such as return on investment (ROI) and economic value added (EVA) (Baker, 2001).

Recent studies report the increasing use of non-financial measures in performance measurement and compensation systems (Baker, 2001; Ittner et al., 2003). These studies suggest that the weight given to financial measures in divisional performance evaluation should be reduced in favour of accounting-based measures, such as ROI and EVA.

The purpose of this paper is to critically review the existing literature on divisional performance measurement. In particular, the paper focuses on the debate between proponents of financial measures, such as ROI, and accounting-based measures, such as EVA. The paper starts with a review of the theoretical literature on divisional performance measurement models. Then, it presents a review of the empirical literature on divisional performance measurement. Finally, it provides a critical assessment of the strengths and weaknesses of different divisional performance measurement models.

2. Theoretical literature review
2.1 Models of divisional performance

There are two main types of models used to evaluate divisional performance: financial models and accounting-based models. Financial models focus on financial measures, such as ROI and economic value added (EVA). Accounting-based models focus on accounting data, such as residual income (RI).

The advantages of financial models are that they are easy to understand and compute, and they provide a clear link between investment decisions and financial outcomes. The disadvantages of financial models are that they ignore non-financial factors, such as customer satisfaction, employee morale, and environmental sustainability.

The advantages of accounting-based models are that they take into account both financial and non-financial factors. The disadvantages of accounting-based models are that they are more difficult to understand and compute, and they provide a less clear link between investment decisions and financial outcomes.

2. 2 Residual income

Residual income (RI) is a measure of divisional performance that takes into account both financial and non-financial factors. RI is computed as the difference between a division’s actual profits and its required profits. Required profits are determined by subtracting a charge for the opportunity cost of capital from a division’s revenues.

The advantage of RI is that it takes into account both financial and non-financial factors. The disadvantage of RI is that it is more difficult to understand and compute than financial measures, such as ROI or EVA.

2. 3 Economic value added

Economic value added (EVA) is a measure of divisional performance that takes into account both financial and non-financial factors. EVA is computed as the difference between a division’s actual profits and its required profits. Required profits are determined by subtracting a charge for the opportunity cost of capital from a division’s revenues.

The advantage of EVA is that it takes into account both financial and non-financial factors. The disadvantage of EVA is that it is more difficult to understand and compute than financial measures, such as ROI or net present value (NPV).

3. Empirical literature review
3.1 Findings

Studies that have compared the use of financial measures and accounting-based measures in divisional performance evaluation have found that:

– The use of accounting-based measures, such as EVA and RI, is associated with improved divisional performance (Baker, 2001; Ittner et al., 2003).
– The use of financial measures, such as ROI and NPV, is associated with decreased divisional performance (Baker, 2001; Ittner et al., 2003).
– The use of accounting-based measures is more effective in evaluating divisional performance than the use of financial measures (Ittner et al., 2003).

3. 2 Conclusions

The empirical evidence suggests that accounting-based measures, such as EVA and RI, are more effective in evaluating divisional performance than financial measures, such as ROI and NPV. This is likely due to the fact that accounting-based measures take into account both financial and non-financial factors.

4. Methodology

This study used a qualitative research methodology. The data were collected from secondary sources, such as academic journals and books. The data were analysed using thematic analysis.

5. Results and discussion
5.1 Return on investment

ROI is a financial measure of divisional performance. It is computed as the ratio of a division’s net income to its total assets. ROI is a popular measure of divisional performance because it is easy to understand and compute. However, ROI has a number of limitations. First, ROI does not take into account non-financial factors, such as customer satisfaction, employee morale, and environmental sustainability. Second, ROI does not provide a clear link between investment decisions and financial outcomes. For these reasons, ROI is not an effective measure of divisional performance.

5. 2 Economic value added

EVA is an accounting-based measure of divisional performance. It is computed as the difference between a division’s actual profits and its required profits. Required profits are determined by subtracting a charge for the opportunity cost of capital from a division’s revenues. EVA is a more effective measure of divisional performance than ROI because it takes into account both financial and non-financial factors. In addition, EVA provides a clear link between investment decisions and financial outcomes.

6. Conclusion

This paper has critically reviewed the existing literature on divisional performance measurement. The paper has concluded that accounting-based measures, such as EVA and RI, are more effective in evaluating divisional performance than financial measures, such as ROI and NPV. This is due to the fact that accounting-based measures take into account both financial and non-financial factors.

FAQ

Return on investment (ROI) is a performance measure used to evaluate the efficiency of an investment or compare the efficiency of a number of different investments.

ROI can be used as a measure of divisional performance by calculating the return that each division generates on its own investments.

The advantages of using ROI as a measure of divisional performance include its ability to directly compare the profitability of different divisions and its focus on overall profitability rather than just sales revenue. However, ROI can be difficult to calculate accurately, and it may not always reflect the true long-term value created by an investment.