196 ACCOUNTING FOR MANAGERS
1 To guide divisional managers in making decisions.
2 To guide top management in making decisions.
3 To enable top management to appraise the performance of divisional manage-
ment.
The decentralization of businesses has removed the centrality of the head office
with its functional structure (marketing, operations, distribution, finance etc.).
Instead, many support functions are now devolved to business units, which may
be called subsidiaries (if they are legally distinct entities), divisions, departments
etc. For simplicity, we will use the term divisionalization although the same
principle applies to any business unit. This divisionalization allows managers to
have autonomy over certain aspects of the business, but those managers are then
accountable for the performance of their business units. Divisionalized business
units may be:
žCost centres– where managers are responsible for controlling costs within
budget limits. Managers are evaluated on their performance compared to
budget by keeping costs within budget constraints.
žProfit centres– where managers are responsible for sales performance, achiev-
ing gross margins and controlling expenses, i.e. for the ‘bottom-line’ profit
performance of the business unit. Managers are evaluated on their performance
compared to budget in achieving or exceeding their profit target.
žInvestment centres– where managers have profit responsibility but also influence
the amount of capital invested in their business units. Managers are evaluated
based on a measure of the return on investment made by the investment centre.
Budgets and performance against budget are the subjects of Chapters 14 and 15.
Evaluating divisional performance in comparison to a strategic investment is the
subject of this chapter.
Solomons (1965) identified the difficulties involved in measuring managerial
performance. Absolute profit is not a good measure because it does not consider the
investment in the business and how long-term profits can be affected by short-term
decisions such as reducing research, maintenance and advertising expenditure.
These decisions will improve reported profits in the current year, but will usually
have a detrimental long-term impact. The performance of divisions and their
managers can be evaluated using two methods: either return on investment or
residual income.
Return on investment....................................
The relative success of managers can be judged by thereturn on investment(or
ROI, which was introduced in Chapter 7). This is the rate of return achieved on the
capital employed and was a method developed by the DuPont Powder Company
early in the twentieth century. Using ROI, managerial and divisional success is
judged according to the rate of return on the investment. However, a problem