198 ACCOUNTING FOR MANAGERS
One of the main problems in evaluating divisional performance is the extent to
which managers can exercise control over investments and costs charged to their
responsibility centres.
Controllability.........................................
The principle of controllability, according to Merchant (1987, p. 316), is that
‘individuals should be held accountable only for results they can control’ (p. 336).
One of the limitations of operating profit as a measure of divisional performance
is the inclusion of costs over which the divisional manager has no control. The
need for the company as a whole to make a profit demands that corporate costs
be allocated to divisions so that these costs can be recovered in the prices charged.
The problem arises when a division’s profit is not sufficient to cover the head office
charge (we introduced this concept in relation to segmentation in Chapter 8).
Solomons (1965) argued that so long as corporate expenses are independent
of divisional activity, allocating corporate costs is irrelevant because a positive
contribution by divisions will cover at least some of those costs.
Solomons separated these components in the divisional profit report, a simpli-
fied version of which is shown below:
Sales £££
Less Variable cost of goods sold £££
Other variable expenses £££ £££
Contribution margin £££
Less Controllable divisional overhead £££
Controllable profit £££
Less Non-controllable overhead £££
Operating profit £££Whilethebusinessasawholemayconsidertheoperatingprofittobethemost
important figure, performance evaluation of the manager can only be carried out
based on the controllable profit. Thecontrollable profitis the profit after deducting
expenses that can be controlled by the divisional manager, but ignoring those
expenses that are outside the divisional manager’s control. What is controllable or
non-controllable will depend on the circumstances of each organization. Solomons
argued that the most suitable figure for appraising divisional managers was the
controllable residual income before taxes. Using this method, the controllable profit is
reduced by the corporate cost of capital. For decisions in relation to a division’s
performance, the relevant figure is thenet residual income after taxes.
One of the problems with both the ROI and RI measures of divisional perfor-
mance is the calculation of the capital investment in the division: should it be total
(i.e. capital employed) or net assets (allowing for gearing)? Should it include fixed
or current assets, or both? Should assets be valued at cost or net book value? Should
the book value be at the beginning or end of the period? Solomons (1965) argued
that it was the amount of capital put into the business, rather than what could be