The Contribution of The Investment Base

The Contribution of The Investment Base We must consider the different elements which go to make up a division's investment separately from the alternative bases on which they may be measured. In considering the former, however, we must once again draw the distinction between measuring the performance of a division and that of its manager. If the purpose is to evaluate the manager's performance, then we should include in the investment base only those assets which are directly traceable to the division and controllable by the manager. Assets which represent the investment in corporate headquarters, as well as any divisional assets which are controlled centrally by head office, should be excluded from this calculation. The fixed assets and stocks of a division are obvious candidates for inclusion, although there could be some dispute over non-productive assets such as vacant land or construction in progress. Similarly, when central management directives force the local management to carry extra stocks or production capacity, there is an argument for excluding the excess amounts. The other elements of working capital - debtors, cash and creditors - can present problems. Although head office might control the day-to-day maintenance of division's sales ledgers, to allow a greater level of efficiency in invoicing and cash collection, if the individual manager sets the sales terms and credit policy for his division, then debtors should be included in the investment base. Invariably, the total cash requirements of all divisions acting as independent units will exceed those of the organization taken as a single entity. In view of the considerable operating economies that can be achieved thereby, many decentralized organizations choose to control their cash cen-trally. While the theoretical approach to allocating cash under such circumstances is simply to determine the incremental amount needed to support each individual division as part of the firm as a whole, it is far from clear how this calculation could be performed satisfactorily in practice, and any alternative basis of allocation such as relative levels of sales - would be open to objection on the part of divisional management. The simplest solution is to disregard all but those cash balances actually held and managed within the division itself. If the divisional manager controls the payments for stock purchases and supplies (including services), he should be encouraged to maximize the use of short-term credit by being allowed to deduct such creditors from his asset base. The treatment will have the effect of increasing both ROI and RI for the division, as example 7 illustrates. Example 7 Division A has the following financial data: Obviously, certain constraints must be placed upon the manager to ensure that he concentrates on seeking out the most favourable credit terms from suppliers rather than jeopardizing the organization's credit rating by simply withholding payments due under the normal terms of trade. This could be achieved by restricting the deductibility of trade creditors to the number of days' purchases represented by the supplier's credit terms, which would not only remove any incentive to unilaterally extend them, but would also (from the individual manager's viewpoint) draw the unwelcome attention of top management to undesirable local activities. The alternative to an asset-based definition of divisional investment would be the 'equity basis', which attempts to measure the shareholders 'equity' in the division (total assets less specific liabilities). Although this might be an appropriate definition for evaluating the operating and financial management of an independent firm, it has little to commend itself in the case of divisionalized activities. In a decentralized firm, the divisional manager is concerned with the management of assets, and not with the long-term sources of finance for those assets, which will normally result from a head office policy decision. Horngren and Foster (1987) demonstrate how the use of an equity basis can distort a comparative performance assessment of two otherwise comparable divisions, and we have adapted this illustration in example.