The Measurement of Investment Center Managerial Performance Within Selected Diversified Industrial Firms: an Inquiry.

Transcription

1 Louisiana State University LSU Digital Commons LSU Historical Dissertations and Theses Graduate School 1975 The Measurement of Investment Center Managerial Performance Within Selected Diversified Industrial Firms: an Inquiry. Janice A. Smith Louisiana State University and Agricultural & Mechanical College Follow this and additional works at: Recommended Citation Smith, Janice A., "The Measurement of Investment Center Managerial Performance Within Selected Diversified Industrial Firms: an Inquiry." (1975). LSU Historical Dissertations and Theses This Dissertation is brought to you for free and open access by the Graduate School at LSU Digital Commons. It has been accepted for inclusion in LSU Historical Dissertations and Theses by an authorized administrator of LSU Digital Commons. For more information, please contact

2 THE MEASUREMENT OF INVESTMENT CENTER MANAGERIAL PERFORMANCE WITHIN SELECTED DIVERSIFIED INDUSTRIAL FIRMS* AN INQUIRY A D i s s e r t a t i o n S u b m itte d t o t h e G ra d u a te F a c u lt y o f th e L o u is ia n a S t a t e U n i v e r s i t y and A g r i c u l t u r a l and M e c h a n ic a l C o lle g e i n p a r t i a l f u l f i l l m e n t o f th e r e q u ir e m e n ts f o r t h e d e g re e o f D o c to r o f P h ilo s o p h y i n The D e p artm en t o f A c c o u n tin g by J a n i c e A. Sm ith B.S., B ry a n t C o lle g e, 1968 M.B.A., O hio U n i v e r s i t y, 1969 D ecem ber, 1975

3 ACKNOWLEDGEMENTS I am i n d e b te d to P r o f e s s o r C. W illa r d E l l i o t t a s d i s s e r t a t i o n com m ittee ch airm a n and t o co m m ittee m embers D r. C, L. Dunn, D r. W. E. S w yers, D r. L. F. M o rris o n, and D r. J. A. W a llin f o r th e d i r e c t i o n o f t h i s s tu d y and f o r th e e n co u rag em en t g iv e n me d u r in g my d o c t o r a l p ro g ra m. A s p e c i a l n o t e o f th a n k s t o D r. E l l i o t t f o r h i s c o n s t r u c t i v e a d v ic e w hich s u b s t a n t i a l l y im p ro v ed th e q u a l i t y o f t h i s d i s s e r t a t i o n an d t o h i s f a m ily f o r t h e i r h o s p i t a l i t y in m aking my s t a y i n L o u is ia n a a l i t t l e more l i k e home. I n a d d i t i o n, I e x p r e s s my a p p r e c i a t i o n to B ry a n t C o lle g e f o r t h e u s e o f i t s co m p u ter f a c i l i t i e s an d f o r i t s f e llo w s h ip f i n a n c i a l s u p p o r t.

4 TABLE OF CONTENTS Page ACKNOWLEDGEMENTS... i i LIST OF TABLES...v i i i LIST OF F IG U R E S... x ABSTRACT... x i C h ap ter 1. INTRODUCTION TO THE STUDY... 1 CHALLENGES TO THE MEASURES... 1 M easurem ent T ool F a ir n e s s... 1 M easurem ent T ool I n d e c is iv e n e s s M easurem ent Tool I n c o n g r u e n c y... 3 GENERALLY ACCEPTED ACCOUNTING PRINCIPLES INTERNAL MEASUREMENT UTILITY... ^ E n t i t y C oncept... 5 C o n tin u ity C oncept... 6 M onetary M easurem ent C oncept... 6 C o st, R e a l iz a ti o n and M atching C oncepts. 7 O b j e c t iv i t y C oncept... 8 C o n sis te n c y, D is c lo s u re and M a t e r i a l i t y C o n c e p t s C o n serv atism C oncept C oncept S u m m ary RESEARCH OBJECTIVE AND SCOPE STATEMENT OF THE HYPOTHESES i n

5 i C h a p te r Page RESEARCH D ESIG N Review o f E x i s t i n g L i t e r a t u r e Q u e s t i o n n a i r e S e n s i t i v i t y A n a l y s i s... 1? TERMINOLOGY ORGANIZATION OF REMAINING CHAPTERS ORGANIZATION OF FIRM SEGMENTS FOR OPERATIONAL AND EVALUATIVE PURPOSES OPERATIONAL SEGMENTATION G e o g ra p h ic a l S e g m e n t a t i o n F u n c tio n a l S e g m e n t a t i o n P ro d u c t-l in e S e g m en tatio n DECENTRALIZATION! THE LINK BETWEEN OPERATIONAL AND EVALUATIVE SEGMENTATION. 2? M eaning o f D e c e n t r a l i z a t i o n R e la tio n s h ip betw een S e g m en tatio n and D e c e n t r a l i z a t i o n D e c e n tr a liz e d D e c isio n Autonomy EVALUATIVE (RESPONSIBILITY) SEGMENTATION. 33 S e g re g a tio n o f S e rv ic e from P r o f i t F u n c t i o n s D e f in i t io n o f Scopei P r o f i t V ersu s In v e s tm e n t C e n te rs SUMMARY MEASUREMENT TOOLS USED IN THE EVALUATION OF INVESTMENT CENTER MANAGERIAL PERFORMANCE. 44 OVERVIEW OF THE INTERNAL MEASUREMENT SYSTEM 44 i v

6 C hapter Page I n t e r n a l V ersus E x te r n a l E v a lu a tio n Firm V ersus Segment E v a lu a tio n Segment M anager V ersu s Segment E v a lu a tio n 47 INVESTMENT CENTER PERFORMANCE EVALUATION TOOLS RETURN ON INVESTMENT RESIDUAL INCOME OTHER FORMS OF INVESTMENT CENTER MANAGERIAL EVALUATION SUMMARY ANALYSIS OF INVESTMENT CENTER PROFITi CONTEXT AND COMPOSITION INVESTMENT CENTER PROFIT EVALUATIONi JUSTIFICATION AND PREREQUISITES ANALYSIS OF VARIOUS CONCEPTS OF PROFIT* DETERMINATION AND SIG N IFIC A N C E C o n tr ib u tio n M a r g i n P erfo rm an ce M a r g i n Segment M a r g i n P r e ta x N et O p e ra tin g Incom e N et O p e ra tin g Income a f t e r Taxes FACTORS CONTRIBUTING TO MANIPULATION AND SUBOPTIMIZATION OF P R O F IT P r o f i t M a n ip u la tio n Exam ples P r o f i t S u b o p tim iz a tio n Exam ples INFLUENCE OF VARIOUS LEVELS OF PROFIT ON ROI* THE SENSITIVITY A N A L Y S IS SUMMARY v

7 C h ap ter P age 5. ANALYSIS OF INVESTMENT CENTER RESOURCE BASE* CONTEXT AND COMPOSITION INVESTMENT BASE* CONTEXTUAL DEFINITIONS. I l l INVESTMENT BASE DERIVATION PROBLEMS CURRENT ASSET COMPONENT OF THE INVESTMENT B A S E V a lu a tio n o f I n c lu d e d C u r r e n t A s s e ts C u rre n t A sse t V a lu a tio n A d ju stm e n ts... 11? C u rre n t A s se t A d d itio n s C u rre n t A sse t D e le tio n s PLANT ASSET COMPONENT OF THE INVESTMENT B A S E... 12? V a lu a tio n o f I n c lu d e d P l a n t A s s e ts. 129 P l a n t A s s e t V a lu a tio n A d ju stm e n ts.... 1^1 P l a n t A s s e t A d d i t i o n s P l a n t A s s e t D e l e t i o n s FINALIZING THE SEGMENT MANAGER'S INVESTMENT BASE* THE ROLE OF L I A B I L I T I E S...1^7 SUMMARY SUMMARY AND CONCLUSIONS CONCLUSIONS RECOMMENDATIONS I n t e r n a l M easurem ent S ystem Use o f ROI and R e s id u a l I n c o m e P r o f i t B ase D e r iv a t io n In v e s tm e n t B ase D e te rm in a tio n R e s id u a l Incom e P e rfo rm a n c e In d e x v i

8 C h a p te r Page THE NEED FOR ADDITIONAL R ESEA RCH... 16$ BIBLIOGRAPHY APPENDICES A. TRANSMITTAL LETTER AND QUESTIONNAIRE B. SENSITIVITY ANALYSIS COMPUTER PROGRAM AND OUTPUT RETURN ON INVESTMENT RESULTS ^ V TTA...217

9 LIST OP TABLES TABLE Page 1. ANALYSIS OF QUESTIONNAIRE RESPONSES BY INDUSTRY GROUPING AND FIRM S I Z E BALANCE S H E E T INCOME STATEMENT DECISIONS AND THE PYRAMID OF AUTHORITY INTRAFIRM SEGMENTAL RESPONSIBILITY DESIGNATIONS ANALYSIS BY INDUSTRY GROUPING INTRAFIRM SEGMENTAL RESPONSIBILITY DESIGNATIONS ANALYSIS BY FIRM S I Z E REPORTED REASONS FOR NOT HAVING INVESTMENT CENTERS INVESTMENT CENTER PERFORMANCE EVALUATIVE TOOLS ANALYSIS BY INDUSTRY GROUPING INVESTMENT CENTER PERFORMANCE EVALUATIVE TOOLS ANALYSIS BY FIRM S I Z E ANALYSIS OF RETURN ON INVESTMENT EVALUATIVE TOOL i ROI TARGET RA TES ANALYSIS OF RESIDUAL INCOME EVALUATIVE TOOL i CAPITAL (INTEREST) CHARGE RATE INDEX OTHER TOOLS USED IN REPLACEMENT OF OR IN ADDITION TO ROI AND RESIDUAL INCOME IN THE EVALUATION OF INVESTMENT CENTER MANAGEMENT EVALUATION OF INVESTMENT CENTER PERFORMANCE MEASUREMENT TOOLS i EFFECTIVENESS AND M OTIVATION ANALYSIS OF ROI PROFIT B A S E ANALYSIS OF SEGMENTAL COMMON COST ALLOCATION METHODS * v m

10 TABLE Page 16. ESTABLISHMENT OF ORIGINAL ROI SENSITIVITY PARAMETERS FOR CORPORATION USED IN SENSITIVITY STUDY... 10? 17. ANALYSIS OF SEGMENTAL INVESTMENT BASE 1 CURRENT ASSET SECTION SENSITIVITY OF ROI ASSUMING INVENTORY VALUATION CHANGED FROM F.I.F.O. TO L.I.F.O. DURING ANALYSIS OF SEGMENTAL INVENTORY TRANSFER PRICES ANALYSIS OF SEGMENTAL INVESTMENT BASEi PLANT ASSET SECTION SENSITIVITY OF ROI ASSUMING UNIFORM DOLLAR PLANT ASSET REPLACEMENT SENSITIVITY OF ROI ASSUMING UNIFORM PERCENTAGE PLANT ASSET REPLACEMENT SENSITIVITY OF ROI ASSUMING THAT THE CHEMICALS SEGMENT ORIGINALLY LEASED 50 PERCENT OF ITS PLANT A S S E T S ANALYSIS OF SEGMENTAL INVESTMENT BASEi ROLE OF LEASED ASSETS ANALYSIS OF SEGMENTAL INVESTMENT BASEi ROLE OF L IA B IL IT IE S SUMMARY OF EVIDENCE TO SUPPORT RESEARCH CONCLUSION i x

11 LIST OP FIGURES FIGURE Page 1. GEOGRAPHICAL VERSUS FUNCTIONAL ORGANIZATIONS RELATIONSHIP OF FACTORS AFFECTING RETURN ON INVESTMENT. V CONFLICT BETWEEN ROI AND PROFIT PERFORMANCE RELATIONSHIP OF FACTORS AFFECTING RESIDUAL INCOME RESOLUTION OF CONFLICT BETWEEN ROI AND PROFIT RESULTS THROUGH RESIDUAL INCOME EVALUATION CONCEPTUAL ILLUSTRATION OF DEGREES OF "NET-NESS" FOR ROI AND RESIDUAL INCOME DETERMINATION MANAGERIAL REINVESTMENT DECISION AND ROI UNDER NET BOOK VALUE MANAGERIAL REINVESTMENT DECISION AND ROI UNDER GROSS BOOK VALUE RECOMMENDED BASIS FOR PROFIT DERIVATION ANNUITY METHOD DEPRECIATION...l 6l x

12 ABSTRACT R eturn on in v e stm e n t and r e s i d u a l income a re m easurement t o o ls t h a t a re w id e ly u se d in th e i n t e r n a l a sse ssm e n t o f in v estm en t c e n te r m a n a g e ria l e f f e c t i v e n e s s. I n i n i t i a t in g t h i s ty p e o f perfo rm an ce e v a lu a tio n, th e n e c e s s i t y o f i n t e r n a l a u t h o r i t y and r e s p o n s i b i l i t y se g m en tatio n c a u se s a p p li c a t io n d i f f i c u l t y t h a t i s n o t e x p e rie n c e d when e v a lu a t i o n i s c o n fin e d e x c lu s iv e ly to th e firm l e v e l. B a s ic a lly, th e problem s in v o lv e d i n s u b e n tity m a n a g e ria l a sse ss m e n ts c o n s is t o f t o o l " u n f a irn e s s " due to an absence o f c o o rd in a t i o n betw een segm ent m anager a c t i v i t y and e f f e c t i v e m easurement o f th e same, t o o l " in d e c is iv e n e s s " cau sed by a la c k o f m easurem ent d i s t i n c t i o n betw een c o n tr o l la b l e and n o n c o n tro l- l a b l e ele m e n ts, and t o o l "incongruency" e v id e n c e d by a c o n f l i c t i n o p tim a l d e c is io n m o tiv a tio n betw een segm ent and to p m anagem ent. The c o n te n tio n o f t h i s stu d y was t h a t a l l th r e e problem a re a s a re d e e p ly r o o te d w ith in th e c o n te x t o f p ro c e d u re s u t i l i z e d in acco rd an ce w ith g e n e r a lly a c c e p te d a c c o u n tin g p r i n c i p l e s. On th e b a s i s o f t h i s p re m ise, th e o b je c tiv e o f t h i s r e s e a r c h was to conduct an i n q u ir y i n to th e m ethods u se d by i n d u s t r i a l c o rp o r a tio n s i n t h e i r e v a l u a tio n o f in v e stm e n t c e n te r m a n a g e ria l p e rfo rm an c e, and a f t e r co m p letin g t h i s in q u ir y, to recommend im provem ents in th e p ro c e d u re s p r e s e n t l y u t i l i z e d. As such, th e d u a l x i

13 h y p o th e s e s w hich form ed th e b a s i s o f t h i s s tu d y w ere a s fo llo w s I 1. The m easurem ent c r i t e r i a p r e s e n t l y u se d i n a s s e s s in g th e e f f e c t i v e n e s s o f in v e s tm e n t c e n t e r m a n a g e ria l p e rfo rm an c e i s in f lu e n c e d to o s t r o n g l y by g e n e r a l l y a c c e p te d a c c o u n tin g p r i n c i p l e s t o be an i n t e r n a l l y m e a n in g fu l e v a l u a tio n, and 2. Too much r e l i a n c e on g e n e r a l l y a c c e p te d a c c o u n tin g p r i n c i p l e s c a u se s d i s t o r t i o n s i n th e e v a l u a t i v e p r o c e s s and may r e s u l t i n m is d ir e c te d m a n a g e ria l m o tiv a tio n w ith r e s p e c t to o p tim iz in g t o t a l company p e rfo rm a n c e. The e v id e n c e a c c u m u la te d i n t h i s s tu d y by m eans o f l i t e r a t u r e e x a m in a tio n, an i n q u ir y q u e s t io n n a ir e, and a com puter s e n s i t i v i t y a n a l y s i s was s u f f i c i e n t to a f f i r m th e g e n e r a l v a l i d i t y o f b o th h y p o th e s e s. D e f in i t e p r o o f o f s u b s t a n t i a l r e l i a n c e on e x t e r n a l l y - o r i e n t e d a c c o u n tin g p r i n c i p l e s was p ro v id e d b y th e q u e s t io n n a ir e a s w e ll a s l i t e r a t u r e and s e n s i t i v i t y b a se d i l l u s t r a t i o n s o f m ea su re m ent b a se d i s t o r t i o n and su b o p tim a l m o tiv a tio n a l p o t e n t i a l t h a t can a r i s e a s a r e s u l t o f u s in g p ro c e d u re s in a c c o rd a n c e w ith th e s e e x te r n a l p r i n c i p l e s. The p rim a ry c a u se o f b o th d i s t o r t i o n and s u b o p tim a l co n seq u en ces was a t t r i b u t e d t o th e em phasis p la c e d on i n a p p r o p r i a t e p r o f i t g o a ls c o u p le d w ith th e b a s ic u n f a i r n e s s o f th e r e s u l t i n g t o o l m e a su re s. On th e b a s i s o f t h i s s t u d y 's f i n d in g s, recom m endations, in te n d e d to p ro v id e a f a i r and e f f e c t i v e b a se f o r m a n a g e ria l * X I 1

14 p e rfo rm an c e a s s e s s m e n t, w ere s y n th e s iz e d. The p rim a ry recom m endation fo c u s e d on th e n e ed t o e s t a b l i s h i n t e r n a l m easurem ent s ta n d a r d s and in c lu d e d th e c o n c e p ts o f re le v a n c e, o p e r a tio n a l in d e p e n d e n c e, c o - v a r i a b i l i t y, and g o a l congruenr cy a s g u id e lin e c o n s i d e r a ti o n s. I n a d d i t i o n, s p e c i f i c m easurem ent p ro c e d u re s were recommended t h a t em phasized d i v i s i b l e m a n a g e ria l r e s p o n s i b i l i t y, c o n t r o l l a b l e p r o f i t and r e s o u r c e d e r i v a t i o n s, and th e n e e d f o r c u r r e n t v a lu a ti o n o f in c lu d e d b a se e le m e n ts. F i n a l l y, th e c o n c lu s io n was re a c h e d t h a t o n ly th e r e s i d u a l incom e t o o l c o u ld be e f f e c t i v e l y a p p lie d i n th e p e rfo rm a n c e a s s e s s m e n t o f an in v e s tm e n t c e n t e r s m anagem ent, and i n t h i s r e s p e c t, a r e s i d u a l incom e p e rfo rm an c e in d e x was d e s ig n e d f o r p u rp o s e s o f i n t e r n a l r e s u l t c o m p a riso n s.

15 C h apter 1 INTRODUCTION TO THE STUDY R e tu rn on in v e s tm e n t and r e s i d u a l incom e a r e two e v a lu a tiv e t o o l s t h a t a re w id e ly u se d to m easure management e f f e c t i v e n e s s ; how ever, th e s e t o o l s a ls o have num erous o th e r a p p l i c a t i o n s. I n t e r n a l l y, th e y a re u se d t o a s s e s s th e p e rfo rm an c e o f a f i r m 's segm ents a s w e ll a s t h e i r management, and th e y a re u se d to e v a lu a te c a p i t a l in v e s tm e n ts. I n a d d i t i o n, th e s e same t o o l s a re w id e ly u se d a s e x t e r n a l m easu res o f th e f i r m 's o v e r a l l f i n a n c i a l p e rfo rm a n c e. On a m acro o r c o rp o r a te l e v e l, th e fo re m o st p ro b lem i n a p p ly in g th e s e c o n c e p ts i s th e d e f i n i t i o n and d e te r m in a tio n o f "incom e" and " in v e s tm e n t b a s e." When th e s e c o n c e p ts a r e i n s t e a d a p p lie d on a m icro o r se g m en tal l e v e l, th e p ro b lem s due t o segment a t i o n a re f a r more i n t e n s e. I n a d d it i o n to th e d i f f i c u l t i e s m en tio n ed above, th e v e ry b a s i s and im p l i c a ti o n s o f th e s e t o o l m easu res a re s u b je c t to c h a lle n g e on s e v e r a l g ro u n d s when th e y a re u se d to e v a lu a te segm ent m anagem ent. CHALLENGES TO THE MEASURES M easurem ent Tool F a ir n e s s T ool f a i r n e s s i s q u e s tio n e d from th e p o in t o f view o f th e segm ent m anager whose p e rfo rm an c e e f f e c t i v e n e s s i s 1

16 2 a s s e s s e d. The c ru x o f t h i s q u e s tio n in g a r i s e s from a n a b sen c e o f c o o r d in a tio n betw een segm ent a c t i v i t y and p ro p e r e v a lu a tio n o f m a n a g e ria l e f f e c t i v e n e s s. T h is o c c u rs because th e m easurem ent p ro c e d u re s m ost o f te n a p p lie d a r e d e e p ly r o o te d w ith in th e c o n te x t o f e x t e r n a l l y - o r i e n t e d g e n e r a l l y a c c e p te d a c c o u n tin g p r i n c i p l e s. F or exam ple, segm ent m anagers o b je c t to r e d u c tio n o f t h e i r segm ent e a r n in g s th ro u g h t a x m in im iz a tio n a c c o u n tin g p ro c e d u re s such a s a c c e l e r a te d d e p r e c i a ti o n and L.I.F.O. in v e n to r y v a l u a t i o n. A lthough c a sh flo w i n a g iv e n y e a r may in c r e a s e th ro u g h a p p ly in g th e s e m easurem ent o p tio n s, n e t p r o f i t (on w hich a m a n a g e r's p e rfo rm an c e i s more o f te n e v a lu a te d ) would l i k e l y d e c l in e. M easurem ent T ool I n d e c is iv e n e s s I n d e c is iv e n e s s r e l a t e s i n p a r t to th e above m en tio n ed q u e s tio n in g o f f a i r n e s s in t h a t th e m easurem ent d e v ic e s p r e s e n t l y u se d o f te n in c lu d e f a c t o r s t h a t a re d o u b tf u l from th e p o in t o f view o f segm ent m anager c o n t r o l l a b i l i t y. T h is i s e v id e n c e d by th e u se o f c o s t a l l o c a t i o n p ro c e d u re s ( i n a cc o rd a n c e w ith th e c o n c e p t o f " f u l l p ro d u c t c o s tin g ) to a s s u r e t h a t each c o r p o r a te segm ent b e a r s i t s r e l a t i v e s h a re o f a l l c o rp o r a te com m itted and d i s c r e t i o n a r y c o s t s. P erfo rm an ce i n d e c is iv e n e s s i s f u r t h e r c o m p lic a te d by th e e x is te n c e o f s h a re d f a c i l i t i e s and in te rs e g m e n t r e l a t i o n s. The im p o rtan c e o f t h i s in d e c is iv e n e s s c h a lle n g e l i e s i n th e f a c t t h a t r e t u r n on in v e s tm e n t and r e s i d u a l incom e a re

17 3 u se d e x c l u s i v e l y by many firm s a s th e s o le b a s i s f o r d e te rm in in g se g m e n ta l i n c e n ti v e bonus a w a rd s. A lso, i t becom es o b v io u s ly m is le a d in g to compare one segm ent w ith a n o th e r f o r p u rp o s e s o f d e te rm in in g th e " b e s t" segm ent m anagem ent. M easurem ent T ool Incongruenc.v E x te n s io n o f th e above a n a l y s i s le a d s i n t o th e l a s t m ajo r d i f f i c u l t y t h i s i s, a la c k o f co n g ru en cy o f te n e x i s t s i n o p tim a l d e c is io n m aking betw een th e m acro system ( f ir m l e v e l ) and i t s m icro su b sy stem s (segm ent l e v e l ) i n a d e c e n tr a li z e d c o r p o r a tio n. The m easurem ent o f se g m en tal p e rfo rm a n c e and th e r a t i n g o f segm ent management b a se d on r e t u r n on in v e s tm e n t and r e s i d u a l incom e a s p r e s e n t l y c a l c u l a t e d may c r e a t e s i t u a t i o n s i n w hich c o n f l i c t o f i n t e r e s t a r i s e s. F o r exam ple, a segm ent m anager may make a d e c is io n n o t to r e p la c e e x i s t i n g f a c i l i t i e s, a d e c is io n w hich i s l i k e l y to b e n e f i t h i s s h o r t - r u n p e rfo rm an c e b u t w hich c o u ld r e p r e s e n t a d e tr im e n ta l d e c is io n from th e company*s lo n g -ru n v ie w p o in t o r, a d e c is io n a f f e c t i n g th e r e l a t i o n s betw een segm ents such a s in te rs e g m e n t t r a n s f e r s may in c r e a s e th e e a r n in g s o f one segm ent a t th e expense o f a n o th e r and p e rh a p s a ls o a t th e s a c r i f i c e o f th e c o rp o ra t i o n a s a w hole. S i t u a t i o n s a r i s i n g r e l a t i v e t o th e above can e a s i l y le a d to c o rp o r a te s u b o p tim iz a tio n. T h is i s e s p e c i a l l y t r u e i f p r o f i t a b i l i t y i s assum ed to be a p rim a ry g o a l and i f r e t u r n on in v e s tm e n t and r e s i d u a l incom e a re

18 1* r e i n f o r c e d a s p rim a ry d e c is io n i n p u t s. S u b seq u en t c h a p te rs w i l l f u l l y e x p lo re t h i s p o t e n t i a l s u b o p tim iz a tio n p ro b lem. GENERALLY ACCEPTED ACCOUNTING PRINCIPLES INTERNAL MEASUREMENT UTILITY Prom th e fo re g o in g d is c u s s io n, i t would a p p e a r t h a t th e p ro b lem s o f f a i r n e s s, in d e c is iv e n e s s and congruency a r e r o o te d w ith in th e c o n te x t o f g e n e r a l l y a c c e p te d acco u n t in g p r i n c i p l e s more s p e c i f i c a l l y, i n th e u t i l i z a t i o n o f p ro c e d u re s flo w in g from th e s e e x t e r n a l l y - o r i e n t e d p r i n c i p l e s f o r p u rp o s e s o f i n t e r n a l l y - o r i e n t e d m easu rem en ts. T h is s e c t i o n b r i e f l y exam ines th e re le v a n c e o f g e n e r a l l y a c c e p te d a c c o u n tin g p r i n c i p l e s from an i n t e r n a l v ie w p o in t. Much o f th e in fo r m a tio n t h a t fo llo w s i s drawn from and b a se d upon r e s e a r c h p e rfo rm ed by S o lo m o n s.* A cco rd in g to Solom ons, th e fram ew ork o f a c c o u n tin g i s composed o f th e fo llo w in g c o n c e p ts i E n t i t y C oncept C o n tin u ity C oncept M onetary M easurem ent C oncept C o st, R e a l iz a ti o n and M atching C oncepts O b j e c t i v i t y C oncept C o n s is te n c y, D is c lo s u re and M a t e r i a l i t y C oncepts C o n se rv a tism C oncept I n th e d is c u s s io n t h a t f o llo w s, each o f th e above c o n c e p ts i s a n a ly z e d i n o r d e r t o a s s e s s i t s d e g re e o f u t i l i t y o r u s e f u l n e s s f o r i n t e r n a l m easurem ent p u r p o s e s. I n c o n d u c tin g *D avid Solom ons, D iv is io n a l P erfo rm a n ce i M easurem ent and C o n tro l (New Yorki F in a n c ia l E x e c u tiv e s R e se arch F o u n d a tio n, 1965), p p. ^

19 5 t h i s a n a l y s i s, c o m p a riso n s a re a ls o made betw een e x te r n a l and i n t e r n a l u t i l i t y a p p l i c a t i o n s. E n t i t y C oncept The d e f i n i t i o n o f th e " e n t i t y i s b a se d upon a l e g a l i s t i c econom ic a c t i v i t y a p p ro a ch and encom passes th e id e a t h a t econom ic a c t i v i t y i s c a r r i e d on th ro u g h s p e c i f i c u n i t s o r e n t i t i e s. Thus, th e a c c o u n tin g e n t i t y i n an e x te r n a l se n se i s d e fin e d i n te rm s o f l e g a l o r g a n iz a tio n ( i. e., th e c o r p o r a t io n ). F or p u rp o s e s o f i n t e r n a l m ea su re s, l e g a l e n t i t i e s have l i t t l e s i g n i f i c a n c e. I n s te a d s e c t o r s w ith in a fir m such a s r e s p o n s i b i l i t y c e n t e r s b e a r f a r g r e a t e r im p o rta n c e. I n a d d it i o n, i t i s v i t a l t o d i s t i n g u i s h betw een v a r io u s ty p e s o f i n t e r n a l e n t i t i e s b e ca u se th e s e e n t i t i e s o f t e n s e rv e d i f f e r e n t p u r p o s e s. For exam ple, i f one i s t r y i n g to e v a lu a te th e p e rfo rm an c e o f a p e rs o n, th e e n t i t y sh o u ld be d e fin e d b y r e f e r e n c e t o th e p e rs o n b e a r in g th e r e s p o n s i b i l i t y f o r i t. I f i n s t e a d, one w ish e s to e v a lu a te th e p e rfo rm a n c e o f an a c t i v i t y ( a s d i s t i n c t from th e p e rs o n r e s p o n s ib le f o r i t ) th e b o u n d a rie s o f th e e n t i t y m ust be r e d e f in e d by r e f e r e n c e to a c t i v i t y c e n te r segm ents ( i. e., m ark et r e g io n s, p ro d u c t l i n e s ). The s i g n i f ic a n c e o f th e s e d i s t i n c t i o n s l i e s i n th e f a c t t h a t in f o rm a tio n c o l l e c t e d f o r one k in d o f e n t i t y e v a lu a t i o n may n o t be a p p r o p r ia te f o r a n o th e r. I n o r d e r to r e c o n c ile i n t e r n a l e n t i t i e s w ith th e e x te r n a l l e g a l o r g a n iz a tio n e n t i t y, a " f i c t i t i o u s c o rp o ra te segm ent th e

20 m is s in g l i n k i s o f te n c r e a te d i n o r d e r to re c o g n iz e s y n e r g i s t i c a l l y t h a t th e w hole i s g r e a t e r th a n th e sum o f i t s com ponent p a r t s. C o n tin u ity C oncent A f u r t h e r o b s e r v a tio n r e g a r d in g th e n a tu r e o f th e a c c o u n tin g e n t i t y i s t h a t th e l i f e o f m ost econom ic u n i t s i s n o t d e te r m in a b le. T h e re fo re, u n d e r th e g o in g -c o n c e m c o n c e p t, th e p re m ise i s ta k e n t h a t u n le s s e v id e n c e e x i s t s to th e c o n tr a r y, th e e n t i t y s h o u ld be view ed a s re m a in in g i n o p e ra tio n i n d e f i n i t e l y. G e n e ra lly sp e a k in g, w ith i n t e r n a l m easu rem en ts, th e c o n t i n u i t y c o n c e p t sh o u ld be e lim in a te d a s a g u id in g p r i n c i p l e. Not o n ly do te rm in a b le e n t i t i e s p l a y a more im p o rta n t r o l e i n i n t e r n a l r e p o r t i n g, b u t re in fo r c e m e n t f o r th e u se o f h i s t o r i c a l c o s t g e n e r a lly f i n d s i t s s u p p o rt i n th e c o n t i n u i t y c o n c e p t. M onetary M easurem ent C oncept The m o n etary m easurem ent c o n c e p t e s t a b l i s h e s money and s p e c i f i c a l l y th e d o l l a r a s th e common d e n o m in a to r o f a c c o u n tin g m easurem ent. The m ost s e r io u s l i m i t a t i o n p e r t i n e n t to b o th e x t e r n a l and i n t e r n a l m ea su re s i s th e i m p l i c i t a ssu m p tio n t h a t th e m o n etary u n i t re m a in s s t a b le o v e r tim e. A lthough u n t i l r e c e n t l y arg u m en ts have been b ro u g h t fo rw a rd to d e fe n d a "do n o th in g " a t t i t u d e re g a r d in g th e p u rc h a s in g pow er o f th e d o l l a r i n e x t e r n a l r e p o r t i n g, i n t e r n a l l y, th e m a tte r i s e n t i r e l y i n th e firm * s own hands

21 s in c e i t i s n o t l i m i t e d b y S.E.C., I. R. S., o r a u d i t o r c e r t i f i c a t i o n c o n s t r a i n t s. F u rth e rm o re, th e m o n etary m easurem ent c o n c e p t does n o t im p ly t h a t m ea su re s i n n o n m o n etary te rm s have no p la c e i n a c c o u n tin g. On th e cont r a r y, th e s m a lle r th e segm ent o r i n t e r n a l e n t i t y, th e more l i k e l y i t sh o u ld be f o r n o n m o n etary m easu res to su p p lem en t o r even r e p la c e some m o n e ta ry m e a s u re s. A lthough t h i s id e a seems to be l o g i c a l, th e q u e s t io n n a ir e r e s u l t s a s s o c i a t e d w ith t h i s stu d y seldom r e f e r to th e u s e o f nonm onetary m easu res i n f o r m u la tin g a s s e s s m e n ts o f se g m e n ta l m a n a g e ria l e f f e c t i v e n e s s. C o st. R e a l iz a ti o n and M atch in g C o n cep ts The above t h r e e c o n c e p ts, c o n s id e re d t o g e t h e r, i d e n t i f y th e e x t e r n a l a c c o u n tin g a p p ro a c h to th e m easurem ent o f p r o f i t. F or i n t e r n a l p u rp o s e s, th e p rim a ry q u e s tio n r e l a t i v e t o th e above p r o f i t m easure i s i how w e ll does each y e a r 's p r o f i t r e f l e c t th e s u c c e s s f u l p e rfo rm an c e o f t h a t y e a r 's m anager? F or exam ple, i t i s q u i t e p o s s i b l e f o r two m anagers to show i d e n t i c a l p r o f i t s o r even i d e n t i c a l r a t e s o f r e t u r n i n th e s h o r t ru n and y e t e x p e rie n c e q u i t e d i f f e r e n t d e g re e s o f s u c c e s s a s a m anager. One m anager may be b u i ld i n g up th e fo u n d a tio n s o f a g r o w th - o r ie n te d segm ent w h ile th e o th e r m anager may be sq u a n d e rin g h i s s e g m e n t's acc u m u late d g o o d w ill. N e ith e r o f th e s e a c t i o n s i s l i k e l y t o show i n th e c u r r e n t p r o f i t c a l c u l a t i o n s. F o r i n t e r n a l a s s e s s m e n ts, t h i s sh o rtc o m in g i s s e r i o u s, e s p e c i a l l y when

22 p r o f i t i s u se d a s a m easure o f m a n a g e ria l e f f e c t i v e n e s s f o r d i r e c t i n g a seg m en t. F u rth e rm o re, i t sh o u ld he n o te d t h a t o n ly u n d e r c o n d itio n s o f u n u s u a l s t a b i l i t y w i l l p r o f i t, a s m easured i n a c c o rd a n c e w ith g e n e r a l l y a c c e p te d a c c o u n t in g p r i n c i p l e s, s a t i s f a c t o r i l y r e f l e c t s h o r t - r u n m a n a g e ria l e f f e c t i v e n e s s. T h is r a i s e s doubt a s to th e r e l i a b i l i t y o f th e o v e r a l l segm ent p r o f i t m easure a s a s u c c e s s i n d i c a t o r. O b j e c t i v i t y C oncent I n an a tte m p t to p ro d u ce e x t e r n a l r e l i a b i l i t y, acco u n t a n t s have tu rn e d to th e c o n c e p t o f o b j e c t i v i t y. The f o llo w in g a re th e two s i d e s o f th e o b j e c t i v i t y coin* V e r i f i a b i l i t y. T h is c o n c e p t im p lie s in d e p e n d e n t v e r i f i c a t i o n o f r e s u l t s. In d e p e n d e n t v e r i f i c a t i o n i s g e n e r a l l y a g re e d to be an o u ts ta n d in g q u a l i t y o f h i s t o r i c a l c o s t, s in c e t h i s c o s t i s d e riv e d from a p a s t t r a n s a c t i o n w hich can be a s c e r t a i n e d and v e r i f i e d. Freedom from b i a s. T h is c o n c e p t im p lie s t h a t th e r e s u l t i n g m easurem ents a r e in d e p e n d e n t o f th e m e a su re r* s p e r s o n a l b i a s. From an i n t e r n a l p o i n t o f view, o n ly th e second s id e o f o b j e c t i v i t y a p p e a rs to be a p p l i c a b l e. I n f a c t, th e c o n ce p t o f o b j e c t i v i t y a s a whole sh o u ld be d e le g a te d to a se co n d a ry r o l e i n th e developm ent o f a c c o u n tin g d a ta. I n i t s p la c e a s a p rim a ry c o n ce p t sh o u ld be i n s e r t e d th e s ta n d a r d o f " r e le v a n c e." C hoosing o b j e c t i v i t y a t th e c o s t o f re le v a n c e ( i. e., h i s t o r i c a l c o s t i s s tr o n g on o b j e c t i v i t y

23 9 b u t o f te n weak on r e le v a n c e ) i s in e x c u s a b le i n i n t e r n a l a c c o u n tin g b e c a u se th e u s e r s o f th e r e s u l t i n g in f o r m a tio n a re known and p resu m ab ly a re h ig h ly k n o w le d g ea b le a b o u t th e b u s in e s s o p e r a tio n s. C o n sis te n c y. D is c lo s u re and M a t e r i a l i t y C oncepts The above c o n c e p ts a r e so c l o s e l y i n t e r r e l a t e d t h a t i t i s b e s t to c o n s id e r d is c u s s io n o f them i n one s e c t i o n. The c o n c e p t o f c o n s is te n c y r e f e r s t o b o th c o n s is te n c y i n th e u se o f a c c o u n tin g p ro c e d u re s o v e r s e v e r a l a c c o u n tin g p e r io d s and i n t e r n a l p r o c e d u r a l c o n s is te n c y f o r h a n d lin g s i m i l a r ite m s i n th e same way w ith in th e same a c c o u n tin g p e r i o d. The r e a l d a n g er i s n o t so much a la c k o f c o n s is te n c y a s i t i s a la c k o f p r o p e r d is c lo s u r e o f a c c o u n tin g c h a n g e s. W hile u n d is c lo s e d changes can be h i g h ly m is le a d in g, d i s c lo s e d changes sh o u ld c l a r i f y a r e a s w here p o s s i b l e m is in t e r p r e t a t i o n c o u ld o c c u r. I n c o n ju n c tio n w ith th e ab ove, th e m a t e r i a l i t y c o n c e p t se e k s to i d e n t i f y d a ta t h a t sh o u ld be d i s c lo s e d. W ith in t h i s fram ew ork, an ite m i s re g a rd e d a s " m a te r ia l" i f t h e r e i s re a s o n to b e lie v e t h a t an in fo rm ed u s e r* s d e c is io n w ould be in f lu e n c e d by th e su b s ta n c e o f th e d a t a. M a t e r i a l i t y d i f f e r s from re le v a n c e in t h a t th e fo rm er r e f e r s to th e " s i g n i f ic a n c e " o f d a ta w ith in a s p e c i f i c c o n te x t, w h ile th e l a t t e r r e f e r s t o th e " c o n te x t" i t s e l f. R eg ard in g i n t e r n a l v e r s u s e x te r n a l v ie w p o in ts, th e p rim a ry d i f f e r e n c e in v o lv e s th e im p o rtan c e t h a t sh o u ld be a tta c h e d to th e c o n s is te n c y c o n c e p t.

24 10 I n t e r n a l l y, much l e s s s i g n i f i c a n c e sh o u ld be a tta c h e d to c o n s i s t e n t a p p l i c a t i o n o f a c c o u n tin g p r o c e d u r e s. I n s t e a d, se g m en tal d e c is io n autonom y sh o u ld d e te rm in e w hich a c c o u n t in g p ro c e d u re s b e s t r e f l e c t th e p e c u l i a r i t i e s o f se g m en tal a c t i v i t y. C o n se rv atism C oncept The en v iro n m en t o f u n c e r t a i n t y h a s p ro v id e d a b a s i s f o r c o n s e rv a tis m i n a c c o u n tin g ; how ever, c o n s e rv a tis m o f te n s e rv e s a s a c o n s t r a i n t to th e p r e s e n t a t i o n o f in f o rm a tio n t h a t o th e rw is e m ight be r e l e v a n t. At b e s t, c o n s e rv a tis m i s a p o o r m ethod o f co p in g w ith th e e x is te n c e o f u n c e r t a i n t y in v a lu a ti o n and incom e. C oncept Summary The t r a d i t i o n a l a p p ro a ch i n e s t a b l i s h i n g a c c o u n tin g p r i n c i p l e s h a s assum ed a c lim a te o f unknown u s e r s w ith in a com plex, u n c e r t a i n e n v iro n m e n t. L i t t l e a t t e n t i o n h a s been d e v o te d to th e q u e s tio n o f w h e th e r a c c o u n tin g c o n c e p ts, a p p r o p r ia te to th e n e e d s o f e x t e r n a l u s e r s, a re a ls o a p p ro p r i a t e to th e n e e d s o f i n t e r n a l m anagem ent. I n 1966, a m ajo r b re a k th ro u g h w ith r e s p e c t to t h i s d i s t i n c t i o n o c c u rre d when th e Com mittee to p re p a r e A S ta te m e n t o f B a sic A ccountin g T heory d e fin e d a c c o u n tin g i n such a way so t h a t th e c o n c e p t o f r e le v a n c e became th e p rim a ry s ta n d a r d.^ 2Com m ittee to P re p a re a S ta te m e n t o f B a sic A cco u n tin g T heory, A S ta te m e n t o f B a sic A cco u n tin g T heory ( I l l i n o i s i A m erican A cco u n tin g A s s o c ia tio n, 1966), P* 7-

25 11 I m p l i c i t l y, th e r e c o g n i ti o n o f r e le v a n c e a s th e p rim a ry s ta n d a r d n e c e s s i t a t e s t h a t a d i s t i n c t i o n be drawn betw een th e n e e d s o f i n t e r n a l and e x t e r n a l u s e r s, a s in fo r m a tio n re le v a n c e would v a ry a c c o r d in g ly. U n f o r tu n a te ly, i n p r a c t i c e t h i s d i s t i n c t i o n h a s n o t b een s u f f i c i e n t l y re c o g n iz e d, a s e v id e n c e d by a s u s p e c te d s tr o n g i n t e r n a l r e l i a n c e on g e n e r a l l y a c c e p te d a c c o u n tin g p r i n c i p l e s f o r p erfo rm an ce m easurem ent p u rp o s e s. RESEARCH OBJECTIVE AND SCOPE The o b je c tiv e o f t h i s s tu d y i s to i n v e s t i g a t e th e r e l a t i o n s h i p s t h a t e x i s t betw een th e c e n t r a l management o f a d i v e r s i f i e d c o r p o r a tio n and th e management o f i t s i n t e r n a l segm ents; an d, a s a r e s u l t o f su ch i n v e s t i g a t i o n, to a r r i v e a t recom m endations w hich sh o u ld r e s u l t i n more e f f e c t i v e c o o rd in a tio n and c o n tr o l o f se g m en tal o p e ra tio n s in a cc o rd a n c e w ith th e o b j e c t i v e s o f th e c o r p o r a tio n. S ta te d i n i t s s im p le s t te rm s, th e q u e s tio n to w hich t h i s stu d y a d d re s s e s i t s e l f i s t how sh o u ld d i v e r s i f i e d firm s m easure and e v a lu a te th e p e rfo rm a n c e e f f e c t i v e n e s s o f m a n a g e ria l segm ents? I n s e e k in g a s o l u t i o n, t h i s stu d y w i l l s y n th e s iz e and recommend im provem ents i n c u r r e n t l y - e x i s t i n g se g m en tal m easurem ent d e v ic e s w ith th e o v e r a l l o b j e c ti v e o f im p ro v in g th e m easurem ent o f m a n a g e ria l e f f e c t i v e n e s s. T h is w i l l in v o lv e an e x a m in a tio n and a sse ss m e n t o f th e f a i r n e s s and adequacy o f th e c o n te x t and

26 12 c o m p o sitio n o f th e t o o l s p r e s e n t l y u s e d. The scope o f t h i s e x a m in a tio n w i l l em phasize th e m easurem ent p ro b lem s a s e x p e rie n c e d by o u r l a r g e s t m u lt i segm ent i n d u s t r i a l c o r p o r a tio n s a s i d e n t i f i e d by F o r tu n e.3 The o v e r a l l d i f f i c u l t i e s o f se g m en tal p r o f i t d e te rm in a tio n and in v e s tm e n t b a se d e r i v a t i o n w i l l be a n a ly z e d a lo n g w ith th e s p e c i f i c p ro b lem s a s s o c i a t e d w ith se g m e n ta l c o s t a l l o c a t i o n s and in te rs e g m e n t t r a n s f e r s. The above f o c a l a r e a s w i l l be exam ined w ith in th e co m p o site problem in v o lv in g m icro s u b o p tim iz a tio n o f m acro o b j e c t i v e s. I n o r d e r to m a in ta in scope m a n a g e a b ility, th e fo llo w in g scope l i m i t a t i o n s have b een i n t e r j e c t e d i 1. R e tu rn on in v e s tm e n t and r e s i d u a l incom e w i l l be exam ined r e g a r d in g t h e i r f a i r n e s s and e f f e c t i v e n e s s a s m a n a g e ria l p e rfo rm an c e e v a lu a tiv e t o o l s, n o t from any o t h e r p o i n t o f view r e f l e c t i n g a l t e r n a t i v e a p p l i c a t i o n s o f th e s e t o o l s. 2. I n t h i s s tu d y, no a tte m p t w i l l be made t o exam ine th e p ro b lem s o f n o n -seg m en ted e n t i t i e s o r n o n - i n d u s t r i a l o r g a n iz a tio n s, a lth o u g h some o f th e p ro b lem s and u ltim a te f in d in g s c e r t a i n l y can be g e n e r a liz e d a s a p p lic a b le to th e s e c o r p o r a t io n s. A lso, th e n a tu r e o f t h i s stu d y -^See ' D ir e c to r y o f th e 500 L a r g e s t I n d u s t r i a l C o rp o rat i o n s, " F o rtu n e. Hay, 197^» PP* * The F o rtu n e d i r e c t o r y o f th e to p 500 i n d u s t r i a l s ( s i z e a s a f u n c tio n o f t o t a l d o l l a r s a l e s ) i s p u b lis h e d on an a n n u a l b a s i s.

27 13 a u to m a tic a lly e x c lu d e s n o n - p r o f i t o rg a n iz e d c o r p o r a tio n s. 3. S p e c if ic t o p i c a r e a s w i l l be exam ined t h a t i n th e m se lv e s c o n s t i t u t e e n t i r e r e s e a r c h s tu d y p r o p o s a ls. As such, no a tte m p t can p o s s i b l y be made to c o m p le te ly r e s o lv e a l l th e p ro b lem a r e a s t h a t w i l l s u b s e q u e n tly be i d e n t i f i e d. An exam ple o f th e above i s th e a r e a o f t r a n s f e r p r i c i n g. I t m ust be em p hasized t h a t t h i s stu d y a p p li e s o n ly to i n t e g r a t e d, m u ltise g m e n te d, i n d u s t r i a l firm s b e ca u se g e n e r a l i z a t i o n s w i l l b e adv an ced t h a t a r e n o t a p p li c a b l e to s m a lle r firm s, f ir m s w ith o u t segm ents o r firm s w ith r e l a t i v e l y in d e p e n d e n t, sem iautonom ous u n i t s whose p e rfo rm an c e i s o n ly a s s e s s e d o v e r a span o f y e a r s. I n a l l such c a s e s, r e t u r n on in v e s tm e n t and r e s i d u a l incom e a r e n o t u s u a l l y a p p lie d, t r a n s f e r p r i c e s a re n o t in v o lv e d, and t h e r e i s l i t t l e o r no p ro b lem o f o p tim iz in g r e l a t i o n s h i p s betw een v a r io u s i n t e r n a l com ponents. STATEMENT OF THE HYPOTHESES T h is r e s e a r c h e n d ea v o r can be sum m arized a s c o n s i s t in g o f i n q u ir y, c o m p a ra tiv e a n a l y s i s and recom m endation s y n th e s i s. W ith in t h i s o v e r a l l fram ew ork, t h i s stu d y w i l l a tte m p t to d e te rm in e th e v a l i d i t y o f th e fo llo w in g a s s e r t i o n s 1 1. The m easurem ent c r i t e r i a p r e s e n t l y u se d i n a s s e s s in g th e e f f e c t i v e n e s s o f in v e s tm e n t c e n te r m a n a g e ria l p e rfo rm an c e i s in f lu e n c e d to o s t r o n g l y by g e n e r a lly

28 1*Ja c c e p te d a c c o u n tin g p r i n c i p l e s to be an i n t e r n a l l y m eaningf u l e v a lu a tio n, and 2. Too much r e l i a n c e on g e n e r a l l y a c c e p te d a c c o u n tin g p r i n c i p l e s c a u se s d i s t o r t i o n s i n th e e v a lu a tiv e p r o c e s s, and may r e s u l t in m is d ir e c te d m a n a g e ria l m o tiv a tio n w ith r e s p e c t to o p tim iz in g t o t a l company p e rfo rm a n c e, RESEARCH DESIGN The r e s e a r c h ap p ro ach u t i l i z e d i n t h i s stu d y c o n s is te d o f t h r e e i n t e r r e l a t e d p h a s e s» Review o f E x is tin g L i t e r a t u r e T h is re v ie w was u n d e rta k e n i n o r d e r to p ro v id e f o r a g e n e r a l d is c u s s io n o f th e segm ented e n t i t y a s w e ll a s o f i t s e v a lu a tiv e d e v ic e s. I n a d d it i o n, t h i s re v ie w a id e d in d e te rm in in g in p u t in q u ir y q u e s tio n s f o r th e q u e s tio n n a ir e s u rv e y. Q u e s tio n n a ire An in q u ir y q u e s tio n n a ir e was m a ile d to th e 500 l a r g e s t i n d u s t r i a l c o r p o r a tio n s a s l i s t e d in th e May, 197^ is s u e o f F o r tu n e. The fir m s su rv e y e d a c c o u n te d f o r 65 p e rc e n t o f a l l U, S. i n d u s t r i a l s a l e s and 79 p e r c e n t o f a l l p r o f i t s d u rin g th e y e a r ^ F or c o n tr o l p u rp o s e s, each su rv e y was v i s i b l y coded. C o rp o ra tio n m a ilin g in f o rm a tio n was ^ I b i d., p p

29 15 o b ta in e d by r e f e r e n c e to Moody*s I n d u s t r i a l Manual. A copy o f b o th th e c o v er l e t t e r o f t r a n s m i t t a l and q u e s tio n n a i r e su rv e y can be lo c a te d i n APPENDIX A. The o v e r a l l o b j e c ti v e s o f t h i s q u e s tio n n a ir e w erei 1. To d e te rm in e th e m anner i n w hich c o r p o r a tio n s c l a s s i f y t h e i r segm ents f o r p e rfo rm an c e r e s p o n s i b i l i t y p u rp o s e s more s p e c i f i c a l l y, t o a s s e s s th e e x te n t to w hich th e s e firm s u t i l i z e th e " in v e s tm e n t c e n te r " r e s p o n s i b i l i t y c o n c e p t, 2. To d e te rm in e th e n a tu r e o f th e m easurem ent t o o l s u se d to a s s e s s se g m en tal m a n a g e ria l p e rfo rm an c e and to d e te rm in e how firm s h a v in g in v e s tm e n t c e n t e r s m easure th e s iz e o f p r o f i t and in v e s tm e n t b a s e, and 3. To p ro v id e in p u t d a ta f o r th e s e n s i t i v i t y a n a l y s i s t h a t was s u b s e q u e n tly d e v elo p ed u t i l i z i n g t r e n d s from th e su rv e y re s p o n s e s. W ith r e s p e c t t o th e q u e s tio n n a ir e re s p o n s e, TABLE 1 (page 16) p r o v id e s a co m p lete breakdow n o f re s p o n s e s r e c e iv e d by b o th s a l e s volume and i n d u s t r y g ro u p in g. TABLE 1 shows t h a t p e r c e n t o r 302 firm s r e t u r n e d a com pleted q u e s tio n n a ir e on a f i r s t re s p o n s e s o l i c i t a t i o n. In a d d it i o n, n o t shown i n t h i s t a b l e i s th e f a c t t h a t 20 firm s re sp o n d e d t o t h i s su rv e y i n q u ir y b u t d id n o t com plete ^See "G e o g ra p h ic a l I n d e x," M oody's I n d u s t r i a l Manual (New York* M oody's I n v e s t o r s S e r v ic e s, I n c., 1973)» p p. 3a - 36a.

30 TABLE 1 ANALYSIS OF QUESTIONNAIRE RESPONSES BY INDUSTRY GROUPING AND FIRM SIZE FIRM SIZE (1973 SALES VOLUME) INDUSTRY GROUPING Less Than $200 M illio n $200 M illio n but Less Than $350 M illio n $350 M illio n but Less Than $500 M illio n $500 M illio n but Less Than $800 M illio n $800 M illio n but Less Than $1 B i l l i o n $1 B i l l i o n but Less Than $2 B i l l i o n $2 B i l l i o n and H ig h er Total Number of Firm s P e rc e n ta g e R a te s A p p lia n c e s /E le c tr o n ic s # C h e m ic a ls/p h a rm a c e u tic a ls * Com m unications # C o m p u ters/o ffice Equipm ent # F ood/b everages/t obacco,., # I n d u s t r i a l Equipm ent # L e is u r e /S p o r tin g Goods # P a p e r/p a p e r P ro d u c ts % P e tro le u m P r o d u c ts /R e fin in g # S c ie n tific /A e r o s p a c e # T e x tile s /A p p a r e l # V e h ic le s /V e h ic le P a r t s.,, # Wood P r o d u c ts /C o n s tru c tio n % M e ta ls /O th e r I n d u s t r i e s # T o ta l Number o f F irm s.,, # P e rc e n ta g e R ates # 23# 17# 16fo 4# 14# # Out o f a t o t a l sam ple o f 500 firm s, 302 com pleted q u e s tio n n a ir e s were re c e iv e d, p ro v id in g a t o t a l r a t e o f r e t u r n o f 60.4?iS.

31 17 a q u e s tio n n a ir e f o r v a r io u s r e a s o n s. The fo re m o st re a s o n c i t e d was t h a t c o rp o r a te p o l i c y i n o p p o s itio n t o e x te r n a l s o l i c i t a t i o n s p re v e n te d them from d o in g s o. I n e sse n c e th e n, th e t o t a l re s p o n s e r a t e by th o s e firm s acknow ledging t h i s in q u ir y was p e r c e n t. Due to t h i s fa v o ra b le i n i t i a l re s p o n s e, no f u r t h e r s o l i c i t a t i o n was th o u g h t to be n e c e s s a r y. S e n s i t i v i t y A n a ly sis I n c o r p o r a tin g o u tp u t t r e n d d a ta from th e q u e s tio n n a ir e w ith in p u t f i n a n c i a l in f o r m a tio n from a s e l e c t e d segm ented c o r p o r a tio n (who w ish e s to rem ain anonym ous), a s e n s i t i v i t y a n a l y s i s was p e rfo rm ed th ro u g h u s e o f a co m p u ter. T h is a n a l y s i s began by e s t a b l i s h i n g i n i t i a l r e t u r n on in v e s tm e n t p a ra m e te r v a lu e s b a se d on t h i s c o r p o r a t i o n 's e x i s t i n g s i t u a t i o n. TABLE 2 (page 18) and TABLE 3 (page 19) o u t l i n e th e b a la n c e s h e e t and incom e s ta te m e n t in f o r m a tio n t h a t was u se d i n s e t t i n g th e s e i n i t i a l ROI p a ra m e te r v a lu e s. S u bsequent p h a se s in v o lv e d t e s t i n g th e s e p a ra m e te r v a lu e s f o r s e n s i t i v i t y by a l t e r i n g th e in p u t in f o r m a tio n. These t e s t p h a s e s in v o lv e d F.I.F.O. to L.I.F.O. c o n v e rs io n, equipm ent re p la c e m e n t and le a s e d a s s e t s. The o v e r a l l o b j e c ti v e s o f t h i s s e n s i t i v i t y a n a l y s i s w erei 1. To i l l u s t r a t e f o r r e a d e r v i s u a l i z a t i o n th e v a s t a r r a y o f p erfo rm an ce r e s u l t d i v e r s i f i c a t i o n t h a t i s i n h e r e n t i n th e r e t u r n on in v e s tm e n t c a l c u l a t i o n, and 2. To s y n th e s iz e recom m endations f o r im provem ent in

32 TABLE BALANCE SHEET ($ OMITTED) DATA FOR CORPORATION USED IN SENSITIVITY ANALYSIS A sse ts C u rre n t A s s e ts j C ash.... I n t r a f i r m R e c e iv a b le s. Trade R e c e iv a b le s... I n v e n to r ie s... T o t. C u rre n t A sse ts. P la n t A s s e ts i N o n d e p re c ia b le, a t c o s t D e p re c ia b le, a t c o s t,. T o ta l, a t C o s t... L essi Acc. D epr.,.. T o t. a t Book V alue.. O th er A s s e ts... T o ta l A s s e ts... E q u itie s C u rre n t L i a b i l i t i e s x I n t r a f i r m P a y a b le s... Trade P ay. & A ccrued.. T o t. C u rre n t Debt,. L-T and D e fe rre d Debt,. T o ta l L i a b i l i t i e s.... S to c k h o ld e rs ' E a u itv... CORP. TOTAL CORP. SEGMENT PRODUCT-GROUPS CONSUMER INDUSTRIAL INDUSTRIAL PROD-LINES PLAS TICS CHEM ICALS SYNTHE TICS (482) ,682 1,046 1, (140) 2,651 3, ,550 9,700 (613) ,199 1x166 2,680 2, , * ,900 3,900 1,000 11, ,282 7,018* 1,900 3,900 1, o , , ,252 4, 608* 1,490 1,950 9f> ,807* *303 (482) , , ,0 4 5 (482) 2,772 2,7 ^ , , * 7, ,4 5 l 2,973* 9 # 1, , ,834 1,700 3,496 2,638 T o ta l E q u i t i e s ^365 10,807* 2, 6^6 4,630 2,m 1 D en o te s p a r t i a l o r c o m p le te n o n a l l o c a t i o n o f f i g u r e s t o p r o d u c t - l i n e se g m e n ts.

33 TABLE INCOME STATEMENT ($ OMITTED) DATA FOR CORPORATION USED IN SENSITIVITY ANALYSIS Revenues* E x te rn a l Net S a le s... I n t e r n a l T r a n s f e r s... O th er R evenues... T o t. Revenues.... V a ria b le Exp. C o n tro lle d * I n t e r n a l T ra n s fe r C o st. C ost o f Goods S o ld... M kt. and Gen. Expense. T o t. V a ria b le Exp.. C o n trib u tio n M argin... C o n tro lle d F ix e d Expense* D epr. on C o n tro l. In v. Segment O verhead.... T o t. C o n tro l. F ix e d. Perform ance M argin.... U n c o n tro lle d F ix ed Exp.* Segment O verhead.... Segment M arg in... S hared Expenses* J o i n t F ix ed C o sts... In c re m e n ta l C e n tr a l.. T o t. A llo c a te d E xp.. N et Income B e fo re Taxes. Taxes on Income.... Net Income A fte r T axes.. CORP. TOTAL 24, CORP. SEGMENT (2,0 0 0 ) ( 2, ooot ( 1, 600) PR0DUCT-GR0UPS CONSUMER INDUSTRIAL 10, i o.i S o 14,110 2, * 16,340* 1,600 7,600 2,3 0 3 INDUSTRIAL PROD-LINES PLAS TICS 3, ,115 CHEM ICALS 5,926 2, ,600 3, SYNTHE TICS 5, *170 14,100 6,500 1,018 2, ^ lo_, 067 (.1*600] 8, j_503 1,535 6,325 3j 643 6,8 3 3 ( ^ o o i 2, * 1,575 1,701 1, ,940 3,440 3, l i ( 400) 1, ,697* , ( ,445* * 42J * ,3 7 3 ( 523) 7 7 2,189* 493 1,01$ $ , f t ( 5231 W * D e n o te s p a r t i a l o r c o m p le te n o n a l l o c a t i o n o f f i g u r e s t o p r o d u c t - l i n e se g m e n ts.

34 20 th e i n t e r n a l m easure o f se g m en tal m a n a g e ria l p e rfo rm a n c e. A copy o f b o th th e com puter program and o u tp u t r e s u l t s r e l a t i v e to th e above s e n s i t i v i t y a n a l y s i s can be lo c a te d i n APPENDIX B. I n a d d it i o n, o u tp u t r e s u l t a n a l y s i s to g e t h e r w ith q u e s tio n n a ir e t a b u l a t i o n s a re in c o r p o r a te d in th e re m a in in g c h a p te r s i n t h i s s tu d y. W ith r e s p e c t to i n t e r p r e t a t i v e a n a l y s i s o f th e q u e s tio n n a ir e and s e n s i t i v i t y stu d y, a s s u ra n c e was g iv e n t o a l l p a r t i c i p a t i n g firm s t h a t t h e i r i n d iv i d u a l re s p o n s e s w ould be h e ld i n s t r i c t c o n fid e n c e, and t h a t any d a ta r e p o r te d w ould be in c lu d e d in t a b l e s w ith o u t d is c lo s u r e o f s p e c i f i c com panies. D isc lo s u r e o f r e s u l t s i n t h i s c o n f i d e n t i a l m anner h a s been f u l l y a d h e re d t o. TERMINOLOGY A d i f f i c u l t y e n c o u n te re d in c o m p ilin g t h i s stu d y in v o lv e d th e s e l e c t i o n and c o n s i s t e n t a p p l i c a t i o n o f v a rio u s te rm s. The fo llo w in g a re th e d e f i n i t i o n s o f key term s u se d i n t h i s s tu d y. O ther term s w i l l be d e fin e d in su b se q u e n t c h a p te r s when i t i s more a p p r o p r ia te to do soi 1. D i v e r s if ie d! A d i v e r s i f i e d firm i s one which p o s s e s s e s two o r more i d e n t i f i a b l e segm ents o f d i s t i n g u i s h a b le c h a r a c t e r i s t i c s. 2. E f f e c tiv e n e s s! E f f e c tiv e n e s s e v a lu a te s th e r e l a t i v e a b i l i t y o f a firm o r firm segm ent to a c h ie v e a p re d e te rm in e d g o a l. I n t h i s s tu d y, e f f e c t i v e n e s s i s n o t

35 21 in te n d e d to be c o n s id e re d a s synonymous w ith th e term " e f f i c ie n c y " th e l a t t e r m eaning a c h ie v in g some o u tp u t u t i l i z i n g a minimum o f e f f o r t, ex pense o r w a s te. Thus, a s i n t e r p r e t e d h e r e, one o f a maximum o f fo u r p e rfo rm an c e c o m b in a tio n s may p r e v a i l i n a g iv e n m a n a g e ria l e v a lu a tio n * Segm ent management may be b o th e f f e c t i v e and e f f i c i e n t, o r Segment managem ent may be e f f e c t i v e, b u t n o t e f f i c i e n t, o r Segment m anagement may be e f f i c i e n t, b u t n o t e f f e c t i v e, o r Segment m anagem ent may be b o th i n e f f e c t i v e and i n e f f i c i e n t. 3. Segm ent«the term segm ent d e s ig n a te s th e p e r f o r mance com ponents w ith in a d i v e r s i f i e d company. The p rim a ry p r e r e q u i s i t e i s t h a t th e d e s ig n a te d com ponents be c l a s s i f i a b le r e s p o n s i b i l i t y - w i s e a s in v e s tm e n t c e n t e r s. As such, segm ents a re a c c o u n ta b le to to p management n o t o n ly f o r p r o f i t a b i l i t y, b u t a ls o a s s e t u t i l i z a t i o n i n t h i s p r o f i t e a rn in g p r o c e s s. 4. In te rse g m e n t* In te rs e g m e n t d e s c r ib e s t r a n s a c t i o n s o r o th e r form s o f i n t e r a c t i o n s e x i s t i n g betw een segm ents o f a f ir m. T h is term c a r r i e s e s s e n t i a l l y th e same m eaning a s th e t e r n " in tra c o m p a n y." 5. S u b o p tim iz a tio n * I n t e r p r e t e d i n th e n e g a tiv e s y n e r g i s t i c se n s e, s u b o p tim iz a tio n s i g n a l s a la c k o f

36 22 con g ru en cy betw een firm and se g m e n ta l o b j e c t i v e s. T h is a d v e rs e e f f e c t i s due t o a c o m b in a tio n o f in te r s e g m e n ta l r e l a t i o n s h i p s and f a u l t y e v a lu a tiv e t e c h n iq u e s. ORGANIZATION OP REMAINING CHAPTERS The re m a in in g c h a p te r s i n t h i s s tu d y a re o rg a n iz e d a s fo llo w s I C h a p te r 2 in v o lv e s an e x a m in a tio n o f d e c e n t r a l i z a t i o n and se g m e n ta tio n f o r o p e r a t io n a l p u rp o s e s and th e e s t a b l i s h ment o f r e s p o n s i b i l i t y c e n te r e v a l u a t i o n p a ra m e te r s. C h a p te r 3 d is c u s s e s th e c o n te x t o f r e t u r n on in v e s tm e n t and r e s i d u a l incom e w ith in th e fram ew ork o f th e i n t e r n a l m easurem ent sy ste m. C h a p te r 4 exam ines th e p ro b lem s in h e r e n t i n p r o f i t d e te r m in a tio n and se g m e n ta tio n ( i. e., c o s t a l l o c a t i o n s ) and th e im p l i c a ti o n s o f th e v a r io u s c o n c e p ts o f p r o f i t. C h a p te r 5 a n a ly z e s th e c o n te x t and c o m p o s itio n o f th e se g m en tal in v e s tm e n t b a s e. C o m p lic a tio n s c a u se d by L.I.F.O. v a lu a ti o n, le a s e d a s s e t s and t r a n s f e r p r i c i n g a r e among th e t o p i c s exam ined. C h a p te r 6, th e f i n a l c h a p te r i n t h i s s tu d y, p r e s e n t s th e o v e r a l l recom m endations i n c o n ju n c tio n w ith t h i s s t u d y 's f in d in g s a lo n g w ith c o n c lu d in g comments and id e a s f o r f u r t h e r r e s e a r c h.

37 C h a p te r 2 ORGANIZATION OF FIRM SEGMENTS FOR OPERATIONAL AND EVALUATIVE PURPOSES O p e ra tio n a l and e v a lu a tiv e s e g m e n ta tio n d i f f e r to th e e x te n t t h a t th e d e fin e d o r g a n i z a t i o n a l o b j e c ti v e, and th u s th e boundary p a ra m e te rs, o f each d i f f e r s. The fo llo w in g s e c tio n s exam ine each form o f s e g m e n ta tio n. OPERATIONAL SEGMENTATION The m ost p ro m in e n t p h y s i c a l b a s e s f o r o p e r a t io n a l se g m e n ta tio n a re by g e o g ra p h ic a l l o c a t i o n, b u s in e s s f u n c tio n and p ro d u c t l i n e. G e o g ra p h ic a l S e g m en tatio n The e a s i e s t o f th e th r e e t o i d e n t i f y i s th e g e o g ra p h i c a l form o f s e g m e n ta tio n. U nder t h i s form o f o rg a n iz a t i o n, a company may l o c a t e i t s h e a d q u a r te r s i n th e n o r th and r e g i o n a li z e i t s s a t e l l i t e segm ents i n th e w e st, e a s t and s o u th. G e o g ra p h ic a l se g m e n ta tio n i s a p p lic a b le in p a r t i c u l a r to th e p r o c e s s i n d u s t r i e s, c h e m ic a ls, o i l r e f i n i n g and s t e e l. H ere, s p e c i a l c irc u m s ta n c e s p la c e a premium on r e g i o n a l i z a t i o n due t o th e n e c e s s i t y o f b e in g c lo s e t o raw m a t e r i a l s, th e h eav y expense o f s h ip p in g f i n is h e d p r o d u c ts and th e r e l a t i v e u n im p o rta n c e o f l a r g e 23

38 zh and d is p e r s e d m a rk e tin g a c t i v i t i e s. F u n c tio n a l S e g m en tatio n Under th e scheme o f f u n c t i o n a l se g m e n ta tio n, each f u n c tio n ( i. e., m a n u fa c tu rin g, s a l e s, fin a n c e ) i s d i r e c t e d on a companywide "b asis. T h is forrti o f o r g a n iz a tio n w orks b e s t i n a company t h a t h a s a s i n g l e p ro d u c t o r i n a company t h a t o p e r a te s in a s in g le hom ogeneous r e g io n. O p e ra tio n a l l y, th e f u n c tio n a l form o f o r g a n iz a tio n w eakens c o n s id e r a b ly when new p ro d u c ts em erge, when s u b s i d i a r i e s a re a c q u ire d o r when new m a rk e ts a re ta p p e d.? P ro d u c t-l in e S eg m en tatio n T h is l a s t m ajo r form o f o p e r a t io n a l se g m e n ta tio n im p lie s m a n a g e ria l r e s p o n s i b i l i t y f o r a l l f u n c tio n s p e r t a i n i n g to th e p a r t i c u l a r p r o d u c t - l i n e u n d e r h i s j u r i s d i c t i o n, A ccording to Bows, one o f th e fo llo w in g b a s ic form s o f o p e r a tio n a l d i v e r s i f i c a t i o n em erges when p r o d u c t - l in e se g m e n ta tio n i s in v o lv e d i H o r iz o n ta l i n t e g r a t i o n. H o r iz o n ta l i n t e g r a t i o n i n d i c a t e s t h a t d i v e r s i f i c a t i o n i s by p ro d u c t r a t h e r th a n W. Cameron C a sw e ll, "T aking S to ck o f D i v i s i o n a l i z a t i o n, " J o u r n a l o f B u s in e s s, 22 ( J u l y, 1956), l 6 l.? D a n ie l L. K urshan, "M eaning o f D e c e n t r a l iz a t i o n," Management R e co rd. 25 (J a n u a ry, 1963)» 8-9. A lbert J. Bows, J r., "Problem s i n D is c lo s u r e o f Segm ents o f C onglom erate C om panies," The J o u r n a l o f A ccountancy. 122 (Decem ber, 1966), 3^-35

39 25 by b a s ic i n d u s t r y. C osm etic and t e x t i l e firm s o f te n u t i l i z e t h i s form o f o r g a n i z a t i o n a l i n t e g r a t i o n. V e r t i c a l i n t e g r a t i o n. V e r t i c a l l y i n t e g r a t e d firm s d i v e r s i f y t h e i r a c t i v i t i e s by i n d u s t r y. They do so w ith th e s i n g u l a r g o a l o f m a n u fa c tu rin g im p o rta n t o v e r a l l end p r o d u c ts. For exam ple, a u to m o b ile com panies f r e q u e n t ly engage i n th e s t e e l, g l a s s and p a r t s i n d u s t r i e s in o r d e r to a tte m p t to c o n tr o l th e c o s t and su p p ly o f th e end p r o d u c ts w hich th e s e i n d u s t r i e s m a n u fa c tu re. Combined i n t e g r a t i o n. T his form o f o r g a n iz a tio n a m ix tu re o f b o th h o r i z o n t a l and v e r t i c a l i n t e g r a t i o n i s t y p i c a l o f co n g lo m era te firm s and in v o lv e s w id e ly d i v e r s i f i e d a c t i v i t i e s in d i f f e r e n t i n d u s t r i e s w hich m anufact u r e num erous end p r o d u c ts. On th e w hole, p r o d u c t - l in e se g m e n ta tio n, r e g a r d l e s s o f th e i n t e g r a t i o n form i t assum es, i s m ost a p p lic a b le to th e m u lti- p r o d u c t, m u lti-m a r k e t, m u lti-p u rp o s e, m a k e -a n d -s e ll i n d u s t r i a l e n t e r p r i s e s. ^ Of th e th r e e m ajo r o p e r a tio n a l p a t t e r n s d is c u s s e d, th e e s ta b lis h m e n t o f se g m en tal b o u n d a rie s i s e a s i e s t to a c h ie v e i n th e f u n c t i o n a l o r g a n iz a tio n. However, a r e l a t e d problem t h a t te n d s to p la g u e f u n c t i o n a l l y - o r i e n t e d to p management i s th e l i m i t e d e x te n t o f d e c is io n a u t h o r i t y t h a t can be d e le g a te d to t h e i r segm ent m an ag ers. T h is a u t h o r i t y ^ C asw ell, op. c i t., p. 161.

40 26 i s f a r more r e s t r i c t i v e o r n a rro w e r th a n i s th e p r o f i t r e s p o n s i b i l i t y f o r w hich to p management w ould i d e a l l y p r e f e r to h o ld segm ent m anagement r e s p o n s i b l e. C o n v e rse ly, d e c is io n a u t h o r i t y d e le g a te d to p r o d u c t - l i n e and r e g io n a l m anagers te n d s t o assume a much b r o a d e r b a se t h a t i s more 10 c o n s i s t e n t w ith t h e i r o v e r a l l m a n a g e ria l r e s p o n s i b i l i t y. F u rth e rm o re, FIGURE 1 shows t h a t t h e r e i s an in v e r s e r e l a t i o n s h i p betw een th e d e g re e o f d e c is io n autonom y p o s s e s s e d and th e num ber o f segm ents a company f i n d s e s s e n t i a l i n o rd e r to a cc o m p lish o v e r a l l o r g a n i z a t i o n a l o b j e c t i v e s. No. o f F irm s I 25 G e o g ra p h ic a l = 2 5 F u n c tio n a l i 5 11 n 6 7 No. o f Firm Segm ents 0 1 FIGURE 1 GEOGRAPHICAL VERSUS FUNCTIONAL ORGANIZATIONS SOURCE 1 A dapted from an i l l u s t r a t i o n by W illiam R. K inney, J r., " C o v a r i a b il i ty o f Segm ent E a rn in g s and M u lti- Segment R e tu r n s," The A cco u n tin g R eview. XLVII ( A p r il, ), 3^3. Gordon S h illin g la w, " D i v i s i o n a l i z a ti o n, D e c e n tr a liz a tio n and R e tu rn on I n v e s tm e n t," N.A.A. B u l l e t i n. M (D ecem ber, 1959)»

41 2? The im p o rtan c e o f th e in f o r m a tio n shown in FIGURE 1 l i e s i n th e f a c t t h a t th e e x te n t o f i n t e r n a l company f r a c t i o n - a l i z a t i o n and i t s d e g re e o f d e c e n t r a l i z a t i o n have much t o do w ith th e e x te n t o f common c o s t a l l o c a t i o n and i n t e r segm ent t r a n s f e r s t h a t s u b s e q u e n tly o c c u r. T h e re fo re, th e more num erous and s m a lle r a re th e segm ents in v o lv e d, th e g r e a t e r te n d s to be th e d e g re e o f i n t e g r a t i o n among them. T h is h ig h e r d e n s i ty o f i n t e g r a t i o n g r e a t l y i n c r e a s e s th e p r o b a b i l i t y o f b o th common c o s t a l l o c a t i o n and in te rs e g m e n t t r a n s f e r o f a s s e t r e s o u r c e s. DECENTRALIZATION* THE LINK BETWEEN OPERATIONAL AND EVALUATIVE SEGMENTATION The t r a n s i t i o n from a c e n t r a l i z e d to a d e c e n tr a li z e d s t r u c t u r e m ost o f te n o c c u rs b e c a u se th e c o m p e titiv e en v iro n m en t e x e r t s c o n tin u in g p r e s s u r e on m anagement to d is c o v e r m ethods o f i n c r e a s in g p r o f i t s. As im p lie d above, e x p a n sio n o f s a l e s o f e x i s t i n g p ro d u c t l i n e s i s one p o s s ib l e s o lu tio n ; d i v e r s i f i c a t i o n i n to new p ro d u c t a r e a s i s a n o th e r. Movement in e i t h e r d i r e c t i o n, and p a r t i c u l a r l y th e l a t t e r, i s l i k e l y to e v e n tu a lly c r e a t e c o n g e s tio n i n th e c o rp o ra te r e s p i r a t o r y sy ste m. As to p management becom es i n c r e a s i n g l y more rem ote from th e d a y -to -d a y o p e r a tin g p ro b le m s, th e o ld f u n c t i o n a l l i n e s o f communicat i o n and r e s p o n s i b i l i t y become i n e f f i c i e n t d e v ic e s f o r th e d e le g a tio n o f d e c isio n -m a k in g a u t h o r i t y. I n th e s i t u a t i o n d e s c rib e d, t r a n s i t i o n to a d e c e n t r a l i z a t i o n s t r u c t u r e i s

42 28 l i k e l y to o c c u r. M eaning o f D e c e n tr a liz a tio n D e c e n t r a l iz a t i o n, a s th e term i s u s e d to d a y, r e f e r s to th e c r e a t i o n o f a num ber o f sem i-autonom ous o p e r a tin g u n i t s w ith in a company, each o f Which i s e x p e c te d to o p e ra te i n s u b s t a n t i a l l y th e same m anner a s a s e p a r a te firm, d ep en d en t on i t s own p r o f i t p e rfo rm an c e f o r econom ic s u r v i v a l. T h e r e f o r e, a c c o rd in g to n o te d a u t h o r i t i e s, d e c e n t r a l i z a t i o n e s s e n t i a l l y means th e d i s p e r s i o n o f d e c isio n -m a k in g a u t h o r i t y, and th u s r e s p o n s i b i l i t y, th ro u g h o u t an o r g a n iz a tio n. The b e n e f i t a c c r u in g to an o p tim a lly d e c e n tr a li z e d system i s t h a t th e n e t e f f e c t o f a l l i n d i v i d u a l se g m en tal d e c is io n a c t io n s w ould be more f a v o r a b le to th e firm a s a whole th a n w ould be th e a c t i o n s e t s s e l e c te d by any o th e r a r r a y o f d e c is io n c e n t e r s. D e c e n tr a liz a tio n by i t s v e ry n a tu r e e n c o u ra g e s i n d i v i d u a l i t y, c r e a t i v e n e s s and freedom. I t s g o a l i s " to c a p i t a l i z e on th e s iz e and p o t e n t i a l s t r e n g th o f th e w hole company, and y e t g iv e segm ents s u f f i c i e n t autonom y so t h a t th e y can r e a l i z e th e a d v a n ta g e s o f a sm a ll o r s in g le u n i t b u s in e s s. ^ G o rd o n S h illin g la w, "P roblem s in D iv is io n a l P r o f i t M easurem ent," N.A.A. B u l l e t i n. ^2 (M arch, ), 33* ^ G e o rg e A lb e rt S m ith, J r., M anaging G e o g ra p h ic a lly D e c e n tra liz e d Companies (B o sto n, M a ssa c h u se tts* H arv ard U n iv e r s ity P r e s s, 1958), p. 3«

43 29 R e la tio n s h ip betw een S e g m en tatio n and D e c e n t r a l iz a t i o n D e c e n t r a l iz a t i o n i s th e l o g i c a l s u c c e s s o r t o segm entat i o n a lo n g p ro d u c t o r r e g io n a l l i n e s. The two d i f f e r p r i m a r i l y i n th e amount o f a u t h o r i t y d e le g a te d to th e segm ent m an ag ers. D e c e n t r a l iz a t i o n, i n e s s e n c e, ad d s to se g m e n ta tio n th e c o n c e p t o f d e le g a te d " p r o f i t " r e s p o n s i b i l i t y. C o n v e rse ly, se g m e n ta tio n adds to d e c e n t r a l i z a t i o n th e o p e ra tio n a.1 m echanism th ro u g h w hich t h e l a t t e r p h ilo s o p h y i s m ost o f te n i n i t i a t e d. D e c e n t r a l iz a t i o n aim s t o r e c r e a t e in th e la r g e o r g a n iz a tio n th e c o n d itio n s t h a t g iv e l i f e and f l e x i b i l i t y to th e sm a ll firm w ith o u t s a c r i f i c i n g th e a d v a n ta g e s o f s i z e. A lthough some com panies have been a b le to d e c e n t r a l i z e w ith in th e fram ew ork o f a f u n c t i o n a l o rg a n i z a t i o n s t r u c t u r e, m ost d e c e n t r a l i z a t i o n r e s u l t s from an o u tg ro w th o f d i s s a t i s f a c t i o n w ith th e a b i l i t y o f f u n c tio n a lis m to s a t i s f y m anagem ent's n e e d t o d e le g a te d e c is io n m aking a u t h o r i t y. T h e re fo re, i t a p p e a rs t h a t a segm ented form o f o r g a n iz a tio n p a v es th e way f o r d e c e n t r a l i z a t i o n and th u s te n d s to a c h ie v e th e d e c e n t r a l i z e r ' s g o a l o f h a v in g d e c is io n s c o n tr o l le d and im plem ented a t r e l a t i v e l y low l e v e l s i n th e o r g a n i z a t i o n. N a tu r a lly, no company i s c o m p le te ly d e c e n t r a l i z e d. I n t h i s r e s p e c t, i n o r d e r to keep d e c e n t r a l i z a t i o n from r e s u l t i n g i n com plete fra g m e n ta t i o n, some p a r t o f th e c e n t r a l c o re m ust rem ain a s th e u n if y in g e le m e n t. I n o th e rw o rd s, w h ile to p management r e l e a s e s th e ro p e s w hich e n a b le v a r io u s movement i n th e

44 30 lim b s o f th e o r g a n iz a tio n, a t th e same tim e i t m a in ta in s a s te a d y g r i p upon a few r e i n s w hich d e te rm in e, to a s i g n i f i c a n t d e g re e, th e d i r e c t i o n and sp eed o f b u s in e s s a c t i v i t y. A ccording to F r a z e r, th e s e c e n t r a l i z e d r e i n s in c lu d e " th e pow er o f th e p u r s e ( o r f i n a n c i a l a c c o u n t a b i l i t y ), " th e pow er o f segm ent m anager d e s tin y " ( o r a d m i n i s t r a t iv e r e s p o n s i b i l i t y ) and " th e pow er o f th e a u d it" ( o r u l ti m a t e c o n t r o l l a b i l i t y ).* - ^ m a tte r o f d e g r e e. T h e re fo re, d e c e n t r a l i z a t i o n i s a I t n o t o n ly v a r i e s from one company to a n o th e r b u t even v a r i e s w ith in th e same company. The p ro b lem in v o lv e d in firm s t r u c t u r e i s n o t so much c e n t r a l i z a t i o n v e rs u s d e c e n t r a l i z a t i o n a s i t i s th e e s ta b lis h m e n t o f a fram ew ork w hich e n a b le s one t o a s s u r e th e e f f e c t i v e o p e r a tio n o f th e o th e r. D e c e n tra liz e d D e c isio n Autonomy "D e le g a te r e s p o n s i b i l i t y alw ay s w ith a u t h o r i t y a s w e ll a s w ith a c c o u n t a b i l i t y. The d e le g a tio n o f r e s p o n s i b i l i t y i s n e c e s s a r y to d e v elo p th e a b i l i t i e s o f man, b u t w ith o u t a u t h o r i t y, i t c r e a t e s f r u s t r a t i o n and d e s tr o y s i ^ i n i t i a t i v e..." From t h i s s ta te m e n t, i t a p p e a rs t h a t *^Chalmus F. F ra z e r, " D e c e n tr a liz a tio n! An A n tid o te to B ig n e s s," P e rs o n n e l A d m in is tr a tio n. M ay-june, i 960, p II F re d e r ic k C. C raw ford, " C re a tin g th e P ro p e r C lim a te," How to I n c r e a s e E x e c u tiv e E f f e c t i v e n e s s, e d. Edward C. B ursk (M a ss a c h u se tts! H arv ard U n iv e r s ity P r e s s, 1953)* p p , c i t e d by Raymond V i l l e r s, "C o n tro l and Freedom i n a D e c e n tra liz e d Company," H arv ard B u sin e ss R eview, 32 (M a rc h -A p ril, 195*0» 96.

45 th e d e c e n t r a l i z a t i o n o f a u t h o r i t y, r e n d e r in g s u f f i c i e n t d e c is io n autonom y, p r o v id e s th e k ey to s u c c e s s f u l v e rs u s u n s u c c e s s f u l seg m en tal o p e ra tio n s * But even th e term " d e c e n t r a l i z a t i o n o f a u t h o r i t y " i s vague and i n d i c a t e s o n ly a p p ro x im a te d e g re e. F or exam ple, in a 1962 su rv e y co n d u cted by Maughan c o v e rin g 300 segm ented f ir m s, some e v id e n c e was found r e g a r d in g th e d e g re e o f d i v e r s i t y in d e c is io n -m a k in g r e s p o n s i b i l i t y. TABLE 4 (page 32) shows Maughan*s f in d in g s w ith r e s p e c t to th e above s u rv e y. To some e x te n t th e v a r i a t i o n shown in TABLE 4 p ro b a b ly r e f l e c t s d i f f e r e n c e s i n th e amount o f d i v e r s i f i c a t i o n and g e o g ra p h ic a l d i s p e r s i o n o f se g m e n ta l a c t i v i t i e s and a ls o th e c o n fid e n c e w hich to p management h a s p la c e d i n segm ent m anagem ent. The i n t e r e s t i n g f a c t t h a t em erges from TABLE ^ i s n o t so much th e a c t u a l p e rc e n ta g e s shown b u t r a t h e r t h a t, i n a l l b u t one o f th e d e c is io n a r e a s l i s t e d, no l e s s th a n s i x d i f f e r e n t l e v e l s o f management a re s a id to p o s s e s s d e c is io n -m a k in g a u t h o r i t y. R e a l i s t i c a l l y th e n, th e r e te n d s t o be a g r e a t d e a l o f v a r i a t i o n from company to company i n th e am ount o f a u t h o r i t y d e le g a te d to segm ent m anagem ent, and seldom i s e x c lu s iv e d e c is io n a u t h o r i t y d e le g a te d t o t h i s l e v e l i n th e o r g a n iz a tio n. The above o b s e r v a tio n, assum ing th e in f o r m a tio n from TABLE 4 h a s r e a s o n a b le v a l i d i t y i n t o d a y 's c o rp o r a te o p e r a tin g e n v iro n m e n t, i s im p o rta n t i n t h a t th e r e s p o n s i b i l i t y v e s te d in a g iv e n segm ent o f te n does n o t c o in c id e

46 TABLE 4 DECISIONS AND THE PYRAMID OF AUTHORITY NATURE OF DECISION BOARD BOARD CHAIRMAN PYRAMID OF DECISION AUTHORITY COMPANY PRESIDENT EXECUTIVE COMMITTEE VICE PRESIDENT SEGMENT MANAGER DEPT. MANAGER LOWER LEVELS In v e s tm e n t/c a p a c ity. 10# 1# 26# 11# 28# 24# New P ro d u c tio n P ro c e s s # 1# 8# # 9# New P ro d u ct I n tr o d u c tio n.., 16# # 32# 2# 1# In v e n to ry Change # 36# 1# 5# D i s t r i b u ti o n Change. 1# 22# 6# '31# 23# 17# A d v e rtis in g Budget. 4# 15# 10# 23# 25# 23# P ackaging R edesign # 24# 33# 32# SOURCE* John Maughan, "Who Makes th e P r o f i t D e cisio n? " Dun s Review and Modem I n d u s t r y, Septem ber, 1962, c i t e d by Solomons, op, c i t., p, 18. VjJ ro

47 33 w ith th e a u t h o r i t y p o s s e s s e d by th e segm ent m anager. F u rth e rm o re, th e q u e s tio n n a ir e r e s u l t s a s s o c i a t e d w ith t h i s stu d y w i l l b e a r o u t th e p re m ise t h a t th e r e e x i s t s some d eg ree o f to p management c o n fu s io n betw een o p e r a tio n a l se g m e n ta tio n and r e s p o n s i b i l i t y se g m e n ta tio n i n th e e v a lu a t i o n o f a segm ent m a n a g e r's p e rfo rm a n c e. S ta te d d i f f e r e n t l y, th e e v a lu a tio n o f a s e g m e n t's o p e r a tin g p e rfo rm an c e ( o r th e e v a lu a tio n o f an a c t i v i t y ) i s n o t n e c e s s a r i l y th e same a s th e e v a lu a tio n o f th e segm ent m a n a g e r's p e rfo rm an c e ( o r th e e v a lu a tio n o f a p e rs o n i n c h arg e o f an a c t i v i t y ). The d if f e r e n c e l i e s p r i m a r il y i n th e b o u n d a rie s a ro u n d w hich th e a r e a o f r e s p o n s i b i l i t y, i n p a r t i c u l a r th e a s p e c t o f c o n t r o l l a b i l i t y, i s s u b s e q u e n tly d e fin e d. The n e x t s e c tio n exam ines th e e s ta b lis h m e n t o f th e s e r e s p o n s i b i l i t y c e n te r p a ra m e te rs. EVALUATIVE (RESPONSIBILITY) SEGMENTATION In a f u l l - s c a l e d e c e n tr a li z e d o r g a n iz a tio n, th e segm ent m anager w ould p o s s e s s com plete a u t h o r i t y and r e s p o n s i b i l i t y f o r th e p e rfo rm an c e o f h i s segm ent. P r i o r to re a c h in g t h i s p o i n t, how ever, to p management m ust be re a s o n a b ly su re t h a t th e segm ent m anagers w i l l alw ay s a c t, to th e b e s t o f t h e i r a b i l i t y, in th e i n t e r e s t o f th e c o r p o r a tio n a s a w hole. T h is means t h a t th e segm ent m anager m ust "know what a c t io n s a re i n th e c o r p o r a t i o n 's b e s t i n t e r e s t, he m ust p o s s e s s th e " c a p a b il i ty " ( d i v i s i b l e

48 a u t h o r i t y a s w e ll a s d i v i s i b l e r e s p o n s i b i l i t y ) to i n i t i a t e such a c t io n s, and he m ust be s u f f i c i e n t l y "m o tiv a te d " to do so. F u rth e rm o re, i f d e c e n tr a li z e d f i n a n c i a l c o n tr o l i s to be e f f e c t i v e, th e segm ent m anager m ust be " e v a lu a te d " on a c t i o n s he does i n i t i a t e so t h a t e f f e c t i v e o r i n e f f e c t i v e p e rfo rm an c e can be a s c e r t a i n e d. T h is l a t t e r p h a se, w hich i s th e f o c a l p o i n t o f t h i s stu d y, i s e x tre m e ly d i f f i c u l t b e ca u se com plex o r g a n iz a tio n s g e n e r a l l y have s e v e r a l g o a ls w hich o v e rla p and t o some d e g re e c o n f l i c t i p r o f i t s, g ro w th, m ark et s h a r e, s o c i a l r e s p o n s i b i l i t y and e t e r n a l l i f e, t o name j u s t a few. Of c o u rs e, p r o f i t s sh o u ld be th e c o r p o r a t i o n s dom inant g o a l i n view o f i t s o b l i g a t i o n to i t s s to c k h o ld e r s and to a f r e e e n t e r p r i s e sy ste m. However, th e s e o th e r o b j e c ti v e s c o n tr ib u te i n d i f f u s e d ways to a tta in m e n t o f lo n g -ru n p r o f i t s, and th u s, c an n o t be c o m p le te ly ig n o re d in m ea su rin g p e rfo rm a n c e. The e x te n t to w hich a l l o f th e above h o ld s t r u e, to a l a r g e d e g re e, d e te rm in e s th e p a ra m e te r b o u n d a rie s aro u n d w hich th e v a r io u s r e s p o n s i b i l i t y c e n te r s a re d e f in e d. I n e s s e n c e, th e p u rp o se o f d e f in in g c e n te r s o f r e s p o n s i b i l i t y i s to overcom e a r e a s o f d i f f u s i o n t h a t would o th e rw is e e x i s t i n th e e v a lu a tiv e p r o c e s s. I n t h i s r e s p e c t, th e r e a re b a s i c a l l y t h r e e ty p e s o f r e s p o n s i b i l i t y c e n te r d e s ig n a t i o n s, nam ely, c o s t c e n t e r s, p r o f i t c e n t e r s and i n v e s t m ent c e n t e r s. The p ro b lem a s s o c i a t e d w ith th e m arking o f f o f r e s p o n s i b i l i t y c e n t e r b o u n d a rie s h a s two r e l a t e d

49 35 d im e n sio n si (1 ) The s e g r e g a tio n o f s e r v ic e f u n c tio n s from p r o f i t c e n t e r s, th e r e b y d e f in in g c o s t c e n t e r s, and (2) The d e f i n i t i o n o f p r o f i t c e n t e r v e rs u s in v e s tm e n t c e n te r r e s p o n s i b i l i t y sc o p e. S e g re g a tio n o f S e rv ic e from P r o f i t F u n c tio n s S e rv ic e c e n t e r s com prise s t a f f a c t i v i t i e s which n o rm a lly c an n o t be s a t i s f a c t o r i l y m easured i n term s o f p r o f i t p e rfo rm a n c e, even though t h e i r s e r v i c e s may c o n t r i b u te s i g n i f i c a n t l y to o v e r a l l company p r o f i t. In g e n e r a l, s e r v ic e a c t i v i t i e s o f t h i s ty p e sh o u ld be c o n s id e re d u n d e r th e u m b re lla o f th e c o s t c e n te r r e s p o n s i b i l i t y d e s ig n a tio n. The p o s i t i o n assum ed h e re i s t h a t i t i s n o t m anagem ent's i n t e n t i o n to make a p r o f i t by s e l l i n g th e s e r v i c e s in q u e s tio n. C ost c e n t e r s. The c o s t c e n t e r r e s p o n s i b i l i t y co n ce p t em braces a m a n a g e ria l r e s p o n s i b i l i t y f o r a l l o p e ra tin g c o s t s o r s a l e s g e n e ra te d w ith in a segm ent, b u t n o t an a s s o c i a t e d r e s p o n s i b i l i t y f o r r e s u l t i n g p r o f i t s. I n a d d it i o n to th e a b o v e-m en tio n ed s e r v ic e a r e a s, D e a r d e n ^ o u t l i n e s th r e e o th e r s i t u a t i o n s u n d e r w hich th e e s t a b l i s h ment o f p r o f i t c e n te r r e s p o n s i b i l i t y, even f o r n o n s e rv ic e a r e a s, w ould be h ig h ly u n l i k e l y. D e a rd e n 's a d d i t i o n a l c o s t c e n te r c o n s id e r a tio n s a re as f o l lo w s» ^ J o h n D earden, "M irage o f P r o f i t D e c e n t r a l i z a t i o n, " H a rv ard B u s in e s s R eview. 4-0 (Novem ber-decem ber, 1962), 150.

50 1. There e x i s t s i n th e c o rp o r a tio n o n ly one m ajo r a c t i v i t y : I f t h i s c o n d itio n h o ld s t r u e, i t i s d o u b tfu l t h a t to p management w i l l d e le g a te a d e q u a te d e c is io n a u to n omy to a segm ent m anager b e c a u se th e a c t i v i t y i s to o im p o rta n t to th e w e lfa re o f th e company, o r 2. There e x i s t s in th e company s e v e r a l m a jo r a c t i v i t i e s : I n t h i s c a s e, due to th e a c t i v i t y c o o r d in a tio n n e c e s s a r y, i t seem l i k e l y t h a t one p e rs o n, n o t s e v e r a l, w i l l make th e k ey d e c is io n s r e g a r d in g th e s e a c t i v i t i e s, o r 3. T here e x i s t s i n d i v i s i b l e r e s p o n s i b i l i t y : I f t h i s c o n d itio n s a r i s e s, th e n th e c o n tr o l t h a t a segm ent m anager can e x e r c is e o v e r h i s p r o f i t i s c o n s id e r a b ly w eakened. The e x is te n c e o f in tra co m p a n y p r i c i n g p ro b lem s and s h a re d f a c i l i t i e s i s som etim es i n d i c a t i v e o f th e f a c t t h a t p r o f i t r e s p o n s i b i l i t y i s i n d i v i s i b l e o r n o t c l e a r l y d e f in e d. D e f in itio n o f Scone: P r o f i t V ersus In v e s tm e n t C e n te rs Once th e c o s t c e n te r r e s p o n s i b i l i t y segm ents have been c l e a r l y i d e n t i f i e d, re m a in in g segm ents i n th e firm a re c l a s s i f i a b l e e i t h e r a s p r o f i t c e n t e r s o r in v e s tm e n t c e n t e r s. P r o f i t c e n t e r s. The p r o f i t c e n te r r e s p o n s i b i l i t y co n cep t i s a p p lic a b le to any s e p a r a t e l y a c c o u n ta b le o rg a n i z a t i o n u n i t t h a t i s r e s p o n s ib le to to p m anagement f o r some f i n a n c i a l m easure o f i t s p r o f i t p e rfo rm a n c e. I n t h i s r e s p e c t, th e com pany's i n t e r e s t l i e s n o t i n m axim izing a p a r t i c u l a r ty p e o f rev en u e o r in m in im iz in g a p a r t i c u l a r ty p e o f c o s t i n i s o l a t i o n, b u t r a t h e r i n m ax im izin g th e

51 37 d if f e r e n c e betw een a l l re v e n u e s and c o s t s. R eg ard in g p r o f i t c e n te r sc o p e, Deanx recommends a p p l i c a t i o n o f th e fo llo w in g fo u r econom ic t e s t s i n m arking o f f p r o f i t c e n te r b o u n d a rie s j 1. O p e ra tio n a l in d ep en d en ce sh o u ld e x i s t. I n o t h e r - w ords, u n le s s a segm ent h a s a la r g e m easure o f indep en d en ce, I t w i l l have in a d e q u a te scope t o re a c h d e c is io n s on a p r o f i t - o r i e n t e d b a s i s, 2. The segm ent m anager sh o u ld have a c c e s s to s o u rc e s and m a rk e ts. In d e p e n d e n t a c c e s s i s e s s e n t i a l i n o rd e r to d e te rm in e m ak e-o r-b u y and m a k e - o r - s e ll d e c i s i o n s. In a d d it i o n, th e p r o f i t - c e n t e r m anager m ust be g e n u in e ly f r e e to buy and s e l l i n a l t e r n a t i v e m a rk e ts b o th i n s id e and o u ts id e th e company, 3. S egm ental c o s ts and re v e n u e s m ust be d i v i s i b l e. P r o f i t c e n te r s sh o u ld be m arked o f f so a s t o m inim ize th e n e c e s s i t y f o r c o s t a l l o c a t i o n s, s in c e th e s e a l l o c a t i o n s a re n e c e s s a r i l y a r b i t r a r y. A lso, a p r o f i t c e n te r m ust be a b le to s p l i t o f f i t s c o s ts and f i n d an e c o n o m ic a lly r e a l i s t i c p r i c e f o r i t s end p ro d u c ts ; o th e rw is e m easurem ent o f i t s p r o f i t p e rfo rm an c e i s im p o s s ib le, and M a n a g e ria l i n t e n t m ust be c o n s i s t e n t. T h is c o n d itio n im p lie s t h a t o n ly i f th e b a s ic g o a l o f th e segm ent i s, in f a c t, p r o f i t s, sh o u ld th e o p e r a tio n o f th e * ^ Jo e l Dean, " D e c e n tr a liz a tio n and In trac o m p a n y P r i c in g, " H arvard B u s in e s s R eview, 33 (J u ly -A u g u s t, 1955)» 67.

52 segm ent be t r e a t e d r e s p o n s i b i l i t y - w i s e a s a p r o f i t c e n te r. 38 In v e s tm e n t c e n t e r s. I n o r d e r to em ploy th e in v e s tm e n t c e n te r c o n c e p t, a company m ust be a b le t o d e c e n tr a li z e i t s p r o f i t r e s p o n s i b i l i t y. I n t h i s r e s p e c t, a p r o f i t c e n te r c o n v e rts i n to an in v e s tm e n t c e n te r when, i n a d d it i o n to s a t i s f y i n g th e a b o v e - o u tlin e d p r o f i t c e n te r c r i t e r i a, th e segm ents a re a ls o each a c c o u n ta b le t o to p management f o r in v e s tm e n t r e s o u rc e u t i l i z a t i o n i n t h i s p r o f i t e a rn in g p r o c e s s. The im p l i c a ti o n, o f c o u rs e, i s t h a t each segm ent m ust be a b le to e x e r c is e c o n s id e r a b le c o n tr o l o v e r th e s iz e and c o m p o sitio n o f i t s in v e s tm e n t b a se a s w e ll a s c o n tr o l o v e r i t s re v e n u e s and e x p e n se s. I n a d d itio n, p erfo rm an ce m easurem ents such a s r e t u r n on in v e s tm e n t and r e s i d u a l income can o n ly be a p p lie d, a c c o rd in g t o th e above d e f i n i t i o n, i n th e e v a lu a tio n o f in v e stm e n t c e n te r p e rfo rm a n c e. W ith th e above s ta te m e n t i n m ind, th e c o r p o r a tio n s p a r t i c i p a t i n g i n th e q u e s tio n n a ir e su rv e y c o n d u cted in t h i s stu d y w ere a sk e d i n what way th e y d e fin e d th e bounda r i e s o f t h e i r i n t e r n a l segm ents f o r r e s p o n s i b i l i t y p u r p o s e s. TABLES 5 and 6 (page 39) sum m arize th e re s p o n se r e c e iv e d to t h i s i n q u ir y. As shown i n th e s e t a b l e s, an overw helm ing m a jo r ity o f la r g e i n d u s t r i a l o r g a n iz a tio n s u t i l i z e th e in v e s tm e n t c e n t e r r e s p o n s i b i l i t y c o n c e p t. The f a c t t h a t so many b u s in e s s e s h a v e, i n r e c e n t y e a r s, fo c u se d i n c r e a s in g a t t e n t i o n on th e e f f i c i e n t u t i l i z a t i o n o f

53 TABLE 5 INTRAFIRM SEGMENTAL RESPONSIBILITY DESIGNATIONS ANALYSIS BY INDUSTRY GROUPING 39 INDUSTRY GROUPING RESPONSIBILITY CENTERS NO PROFIT/ INVESTMENT CENTERS PROFIT CENTERS INVESTMENT CENTERS A p p lia n c e s /E le c tr o n ic s C h e m ic a ls /P h a rm a c e u tic a ls C om m unications C o m p u te rs/o ffic e E quipm ent. 2 6 F o o d /B e v e ra g e s/t o b a c c o I n d u s t r i a l E quipm ent L e i s u r e /S p o r ti n g G oods P a p e r/p a p e r P r o d u c ts P e t r o. P r o d u c ts /R e f in in g S c i e n t i f i c / A e r o s p a c e., T e x tile s /A p p a r e l V e h ic le s /V e h ic le P a r t s Wood P r o d u c ts /C o n s tr u c tio n M e ta ls /O th e r I n d u s t r i e s T o ta l Number o f F irm s P e rc e n ta g e R ates*... 2% 27# 71# TABLE 6 INTRAFIRM SEGMENTAL RESPONSIBILITY DESIGNATIONS ANALYSIS BY FIRM SIZE FIRM SIZE RESPONS][BILITY CENTERS NO PROFIT/ INVESTMENT CENTERS PROFIT CENTERS INVESTMENT CENTERS AT LEAST - LESS THAN No Minimum - i5200 M illio n 9 14 J5200 M illio n - I5350 M illio n VO50 M illio n - J5500 M illio n S5500 M illio n - I5800 M illio n M illio n - {51 B i l l i o n. 7 7 $1 B i l l i o n - 52 B i l l i o n $2 B i l l i o n - No Maximum T o ta l Number o f Firm s P e rc e n ta g e R a te s*... 2# 27# 71# SOURCE* C o rp o ra tio n s re s p o n d in g to q u e s t io n n a ir e. *302 firm s e q u a ls 100# f o r TABLES 5 and 6.

54 seg m en tal a s s e t s i s t o be a p p la u d e d. I n te rm s o f c o n c e p t e v o lu tio n, th e i n t r o d u c t i o n o f th e p r o f i t c e n te r c o n c e p t, p o p u la riz e d d u rin g th e 1950' s, was a s i g n i f i c a n t advance o v er p re v io u s e x c lu s iv e u s e o f seg m en tal c o s t c e n t e r s. L ik e w ise, th e in c r e a s in g u se o f th e in v e s tm e n t c e n te r c o n ce p t r e p r e s e n ts an even g r e a t e r im provem ent o v e r th e p r o f i t c e n te r c o n c e p t. E n co u ra g in g a m anager to fo c u s h i s a t t e n t i o n n o t o n ly on p r o f i t s, b u t a ls o on th e in v e s tm e n t r e q u ir e d to p ro d u ce t h a t p r o f i t, r e p r e s e n t s a welcome re fin e m e n t to th e th e o r y o f d e c e n t r a l i z a t i o n. Of c o u rs e, n o t a l l c o r p o r a tio n s e i t h e r d e s i r e o r have o p e ra t i o n a l u se f o r th e in v e s tm e n t c e n t e r c o n c e p t. TABLE 7 (page 4 l ) o u t l i n e s th e r e a s o n s p ro v id e d by th e 87 firm s who had in d ic a t e d i n TABLES 5 and 6 t h a t th e y d id n o t u t i l i z e th e in v e s tm e n t c e n te r r e s p o n s i b i l i t y c o n c e p t. As shown in TABLE 7, th e v a s t m a jo r ity o f firm s i n d ic a t e d h ig h ly v a l i d and u n d e rs ta n d a b le re a s o n s f o r n o t h a v in g in v e s tm e n t c e n t e r s. SUMMARY From th e fo re g o in g, i t w ould a p p e a r t h a t th e m odem, i n t e g r a t e d, m u ltip le - p r o d u c t, p r o f i t - o r i e n t e d firm f u n c tio n s m ost s u c c e s s f u ll y i f i t i s com prised o f d i v i s i b l e o p e r a tin g u n i t s, each p o s s e s s in g th e fo llo w in g c h a r a c t e r i s t i c s! 1. O p e ra tio n a l In d ep en d en ce 1 O p e ra tio n a l in d ep en d en ce i s n e c e s s a r y in o rd e r to make s e p a r a te p r o f i t and r e s o u rc e

55 kl TABLE 7 REPORTED REASONS FOR NOT HAVING INVESTMENT CENTERS REASONS CITED TOTAL FIRMS FREQUENCY PERCENTAGE OF TOTAL TOTAL FIRMS 100# D e sire f o r c e n t r a l i z e d c o n tr o l o v e r m ajo r d e c is io n s ( la c k o f se g m en tal d e c is io n au to n o m y ) # S egm ental f a c i l i t i e s a re h ig h ly i n t e r r e l a t e d and com plem entary. 2k 28# In v e stm e n t c e n te r c o n ce p t i s n o t a p p lic a b le to th e n a tu r e o f th e f i r m s o p e r a t io n a l p h ilo s o p h y # 87 Firm i s c u r r e n t l y i n th e p r o c e s s o f c o n v e rtin g i t s r e s p o n s i b i l i t y segm ents from p r o f i t to in v e s tm e n t c e n t e r s # O th e r re a s o n s c i t e d... 3 kfo T o ta l R esponse to I n q u ir y * 8 6fo* Q*?** SOURCE: C o rp o ra tio n s re s p o n d in g to q u e s t io n n a ir e. R esponse p e rc e n ta g e i s l e s s th a n 100# b e ca u se 12 o ut o f 87 firm s n o t h a v in g in v e s tm e n t c e n te r s d id n o t g iv e an answ er to t h i s i n q u ir y. In fo rm a tio n d e riv e d from TABLES 5 and 6.

56 42 r e s p o n s i b i l i t y a r e a l i t y ; how ever, i f s e l f - c o n t a i n e d to th e ex trem e, th e v e ry id e a o f a segm ent a s b e in g an i n t e g r a l p a r t o f a g r e a t e r whole w ould be d e s tr o y e d, 2. In te r s e g m e n ta l C o o p e ra tio n! H aving c a l l e d above f o r a s u b s t a n t i a l d e g re e o f in d e p e n d e n c e, what i s b e in g a d v o c a te d a ls o i s a c e r t a i n d e g re e o f c o o p e r a tio n o r in te rd e p e n d e n c e. I n o th e rw o rd s, i f a segm ent, w h erev er p o s s ib l e, c o n tr i b u te s to th e s u c c e s s o f o th e r segm ents a s w e ll a s to i t s e l f, t h i s segm ent w i l l, by im p l i c a ti o n, a ls o c o n tr ib u te to th e s u c c e ss o f th e co m p o site c o rp o ra te w hole. T h is c o n tr i b u ti o n may assum e num erous fo rm s. F or exam ple, two o r more segm ents may p ro d u ce com plem entary p r o d u c ts, th e s a l e o f one segm ent*s p r o d u c ts h e lp in g to c r e a te demand f o r a n o t h e r 's, 3. A f u r t h e r q u a l i t y f o r s u c c e s s i s t h a t r e l a t i o n s betw een segm ents sh o u ld be so o rg a n iz e d t h a t no s in g le segm ent, by se e k in g i t s own p r o f i t, can re d u c e th e p r o f i t f o r th e e n t e r p r i s e a s a w hole. P ro p e r b o u n d ary d e f i n i t i o n can h e lp to m inim ize t h i s form o f su b o p tim a l a c t i v i t y, and 4. A dequate d e c is io n a u t h o r i t y sh o u ld be v e s te d in th e segm ent m anager. T h is d e le g a te d a u t h o r i t y sh o u ld le a v e to th e segm ent m a n a g e r's d i s c r e t i o n n o t o n ly "how th e o p e r a tio n s o f h i s segm ent sh o u ld be c a r r i e d o u t, b u t a ls o, w ith in l i m i t s, "w hat" th e n a tu r e o f th o s e o p e r a tio n s sh o u ld b e. In summary, i f th e above seg m en tal q u a l i t i e s p r e v a i l

57 i n any g iv e n c o r p o r a tio n, th e n each segm ent i n se e k in g to m axim ize i t s own p o t e n t i a l w i l l a l s o m axim ize th e p o t e n t i a l o f th e e n t i r e e n t i t y. U t i l i z i n g th e in v e s tm e n t c e n t e r r e s p o n s i b i l i t y b o u n d a rie s, a s o u t li n e d w ith in t h i s c h a p te r, a d is c u s s io n o f in v e s tm e n t c e n te r p erfo rm an ce e v a lu a tiv e t o o l s w i l l now ta k e p l a c e. In t h i s r e s p e c t, th e m easurem ent t o o l s commonly u se d i n th e e v a lu a tio n o f in v e s tm e n t c e n te r manag e r i a l p erfo rm an ce a re exam ined c o n te x tu a l ly in th e n e x t c h a p te r.

58 C h a p te r 3 MEASUREMENT TOOLS USED IN THE EVALUATION OF INVESTMENT CENTER MANAGERIAL PERFORMANCE In th e e v a lu a tio n o f i n t e r n a l m a n a g e ria l seg m en ts, two o b j e c ti v e s e x i s t i To g u id e th e segm ent m anager whose p e rfo rm an c e e f f e c t i v e n e s s i s a s s e s s e d, and t o a s s i s t to p management in i t s ta s k o f a p p r a i s i n g se g m en tal p erfo rm an ce r e s u l t s. OVERVIEW OF THE INTERNAL MEASUREMENT SYSTEM In view o f th e above o b j e c t i v e s, th e m easurem ent sy stem u se d i n t h i s e v a lu a tio n sh o u ld a s s i s t and m o tiv a te segm ent management in th e f o rm u la tio n o f b u s in e s s d e c is io n s t h a t w i l l m axim ize th e p o t e n t i a l o f th e e n t i r e o r g a n iz a t i o n. In a d d it i o n, t h i s same m easurem ent system sh o u ld p ro v id e to p management w ith a r e l i a b l e and f a i r in d e x o f seg m en tal management p r o g r e s s to w a rd th e ach iev em en t o f c o rp o ra te g o a ls. A d m itte d ly, f u l l accom plishm ent o f th e above o b je c tiv e s te n d s to be more i d e a l i s t i c th a n r e a l i s t i c. Much o f t h i s nonaccom plishm ent d i f f i c u l t y h a s to do w ith a la c k o f i n t e r n a l (a s opposed to e x te r n a l) m easurem ent r e fin e m e n t a s w e ll a s a g e n u in e c o n fu s io n o f th e i n t e r n a l and e x te r n a l m easurem ent sy s te m s. These problem a r e a s te n d to

59 ^5 be s p e c i f i c a l l y r e f l e c t e d i n th e fo llo w in g k ey a r e a s o f e v a l u a t i o n. I n t e r n a l V ersu s E x te r n a l E v a lu a tio n W ith r e s p e c t to i n t e r n a l v e r s u s e x t e r n a l m easurem ent sy ste m s, much o f th e c o n fu s io n l i e s in th e f a i l u r e to re c o g n iz e th e n e c e s s i t y o f d i f f e r e n t a c c o u n tin g d a ta f o r d i f f e r e n t e v a lu a tiv e n e e d s. More s p e c i f i c a l l y, a d i s t i n c t i o n sh o u ld be drawn betw een p u b lis h e d f i n a n c i a l d a ta and f i n a n c i a l d a ta p ro d u c e d and u se d s o l e l y w ith in th e c o n fin e s o f a p a r t i c u l a r company. Numerous exam ples can be c i t e d w here t h i s d i s t i n c t i o n sim p ly h a s n o t b e en m ade. F or exam ple, a c c o u n tin g d a ta f o r p u rp o s e s o f p u b lic r e p o r t i n g m ust a d h e re t o s p e c i f i c a t i o n s g o v ern ed by g e n e r a l l y a c c e p te d a c c o u n tin g p r i n c i p l e s, one o f w hich in v o lv e s p r o c e d u r a l c o n s is te n c y. F or p u rp o s e s o f i n t e r n a l m easurem ent in v o lv in g firm seg m en ts, p r o c e d u r a l c o n s is te n c y a s w e ll a s seg m en tal d a ta u n if o r m ity n e ed n o t e x i s t. T h is s e n tim e n t was p ro b a b ly b e s t e x p re s s e d by John H artm ann i n h i s 1968 sp eech to th e T ulane Symposium when he r e p o r te d i " I n t e r n a l a c c o u n tin g p r i n c i p l e s a r e th o s e w hich work f o r a p a r t i c u l a r company. T here i s no n e e d f o r them to have been a c c e p te d by anyone e l s e, n o r n e ed th e y be c o n s i s t e n t e i t h e r companywide o r from p e r io d to p e rio d.'*!? Jo h n J. H artm ann, "A View from M anagem ent," P u b lic R e p o rtin g by C o n g lo m erates (New J e r s e y i P r e n t ic e - H a l l, I n c., 1968), p. 67, c i t e d by R. K. M autz, F in a n c ia l R e p o rtin g by D i v e r s i f i e d Com panies (New Y orki F in a n c ia l E x e c u tiv e s R e se a rc h F o u n d a tio n, 1968), p. 2 3.

60 46 The fo re g o in g i s n o t in te n d e d t o im p ly t h a t d a ta f o r i n t e r n a l p u rp o se s sh o u ld n o t m eet r i g o r o u s s ta n d a r d s j r a t h e r, th e p rim a ry p o i n t to be made i s t h a t m anagem ent, u s in g i t s own i n t e r n a l s ta n d a r d s, sh o u ld be a b le t o g e n e r a t e r e l e v a n t d a ta f o r each ty p e o f s i t u a t i o n o r e v a lu a tiv e n eed t h a t a r i s e s. In su b se q u e n t c h a p te r s, f u r t h e r e v id e n c e w i l l be p ro v id e d r e l e v a n t to th e p re m ise t h a t i n t o d a y 's te c h n o lo g i c a l ly s o p h i s t i c a t e d and com plex c o r p o r a te s o c ie ty, t h e r e s t i l l e x i s t s a s tr o n g r e l i a n c e on g e n e r a l l y a c c e p te d a c c o u n tin g p r i n c i p l e s f o r i n t e r n a l l y - o r i e n t e d e v a l u a t i o n s. T h is, i n i t s e l f, i s n o t to o s u r p r i s i n g when one c o n s id e r s th e f a c t t h a t c o n v e n tio n a l a c c o u n tin g sy stem s h av e te n d e d to grow i n re s p o n s e to e x t e r n a l f o r c e s. A c c o rd in g ly, i n th e w ords o f F air«"very few p e o p le i n b u s in e s s have had th e o p p o r t u n i t y to r e f l e c t on th e way i n w hich th e a c c o u n tin g m odel d e v e lo p e d, p a r t i c u l a r l y on how an in s tr u m e n t w e ll a d a p te d to d e t e c t fra u d and m easure t a x l i a b i l i t y h a s g r a d u a lly been u se d a s a g e n e r a l in fo rm a tio n s o u rc e. H aving become accustom ed to in fo r m a tio n p r e s e n te d in t h i s form, b u s in e s s p e o p le have a d a p te d t h e i r c o n c e p ts and p a t t e r n s o f th o u g h t and communicat i o n t o i t r a t h e r th a n a d a p tin g th e in fo r m a tio n t o th e job o r p e rs o n..."1 8 Firm V ersus Segment E v a lu a tio n When a firm i s o rg a n iz e d aro u n d in v e s tm e n t c e n t e r s, 18 W illiam R. F a i r, "The N ext S te p in Management Cont r o l s, " Management C o n tro l S y stem s, e d. A lan J. Rowe (New York* John W iley and S ons, I n c., i ), p p , c i t e d by C h a rle s T. H o m g ren, "C hoosing A l t e r n a ti v e A ccountin g P r a c t i c e s f o r R e p o rtin g t o M anagem ent," N.A.A. B u l l e t i n. 44 (S eptem ber, 1962), 3.

61 i t i s g e n e r a l l y d e s i r a b l e to h av e th e sum o f a l l th e 47 i n d iv i d u a l segm ent r e s o u r c e s and e a rn in g s e q u a l to t h a t d e te rm in e d f o r th e company a s a w hole a t l e a s t t h i s i s th e se n tim e n t im p lie d by g e n e r a lly a c c e p te d a c c o u n tin g p r i n c i p l e s. The j u s t i f i c a t i o n f o r t h i s e q u a l i t y i s t h a t i t i s e a s i e r to make in te rs e g m e n t p e rfo rm an c e co m p ariso n s and a ls o a v o id s th e p ro b lem o f e s t a b l i s h i n g one s ta n d a r d r a t e o f r e t u r n f o r th e company a s a w hole and a n o th e r r e t u r n r a t e f o r each o f i t s com ponent p a r t s. I n d is p u te o f th e s e a rg u m e n ts --s in c e management i s co n ce rn e d w ith se g m e n ta l e v a lu a tio n in i t s e l f i t i s im m a te ria l t h a t th e b a s i s on w hich t h i s e v a lu a tio n i s form ed d i f f e r s from e i t h e r o th e r segm ents o r th e b a s i s u se d i n e x t e r n a l c o rp o r a te r e p o r t i n g. In a d d it i o n, th e s y n e r g i s t i c e f f e c t o f c o n s o lid a te d e f f o r t s on th e c o rp o r a te l e v e l sh o u ld c au se th e com bined r e s u l t s o f th e w hole to be g r e a t e r th a n th e sum o f i t s s e p a r a te p a r t s. T h e re fo re, th e sum o f se g m en tal a c t i v i t y n e e d n o t and m ost l i k e l y sh o u ld n o t e q u a l th e sum o f th e w h o le. What i s o f s i g n i f ic a n c e i s t h a t segm ent m anagers r e a l i z e t h a t any a c t io n s ta k e n on t h e i r p a r t sh o u ld c o n tr i b u te t o, n o t d e t r a c t from, o b tain m en t o f o v e r a l l c o rp o ra te g o a ls. Segment M anager V ersu s Segment E v a lu a tio n Much o f th e l i t e r a t u r e w r i t t e n on th e s u b je c t o f d e c e n tr a li z e d p erfo rm an ce e v a lu a tio n f a i l s t o d i s t i n g u i s h betw een th e segm ent and th e segm ent m anager i n p e rfo rm an c e m easurem ent. The end r e s u l t o f f a i l i n g to draw t h i s

62 48 d i s t i n c t i o n th ro u g h b o u n d ary l i n e d e f i n i t i o n i s p o s s ib l e su b o p tim a l b e h a v io r. T h is p o t e n t i a l s u b o p tim iz a tio n p ro b lem w i l l be d is c u s s e d i n added d e t a i l in s u c c e e d in g c h a p te r s. The fo c u s o f t h i s l a t e r d is c u s s io n w i l l c e n t e r on p r o p e r v e rs u s im p ro p e r m a n a g e ria l m o tiv a tio n i n p r o v id in g a c a u se - a n d - e f f e c t r e l a t i o n s h i p. The above s e c tio n i l l u s t r a t e s how im p e r f e c t and u n r e f in e d th e i n t e r n a l m easurem ent fram ew ork a c t u a l l y i s and i s o l a t e s some s p e c i f i c p ro b lem s t h a t e x i s t. I n a d d i t i o n, th e te n d e n c y f o r se g m en tal in te r c h a n g e w ith o th e r segm ents c o u p le d w ith th e s u p p o rt w hich one segm ent le n d s to a n o th e r and th e com pany's p la n s f o r one segm ent v e r s u s a n o th e r, a l l combine to make th e e v a lu a tio n o f i n d iv i d u a l segm ents and t h e i r m anagement m ost d i f f i c u l t. The n e x t s e c tio n d is c u s s e s th e m easurem ent t o o l s t h a t a r e u s e d in a tte m p tin g to r e s o lv e t h i s e v a lu a tio n p ro b lem. INVESTMENT CENTER PERFORMANCE EVALUATION TOOLS I n m e a su rin g th e e f f e c t i v e n e s s o f an in v e s tm e n t c e n te r m anager, th e r e a re two b a s i c p h i lo s o p h ic a l a p p ro a c h e si M easurem ent and e v a lu a tio n o f p r o f i t and in v e s tm e n t can be p e rfo rm e d a s s e p a r a te e v a lu a tio n s, o r p r o f i t and in v e s tm e n t can be com bined i n to a s in g le m easure o f m a n a g e ria l e f f e c t i v e n e s s. Those c o r p o r a tio n s t h a t have r e s o r t e d t o t h i s l a t t e r m easurem ent p h ilo s o p h y have a tte m p te d t o acc o m p lish t h e i r o b je c tiv e th ro u g h e i t h e r th e c a l c u l a t i o n o f a r a t i o

63 ^9 r e f e r r e d to a s r e t u r n on in v e s tm e n t (ROI) o r th ro u g h a r e l a t e d m easure known a s r e s i d u a l incom e. I n a p p ly in g e i t h e r m easu re, th e "basic th e o r y i s th e same; t h i s i s, i f each in v e s tm e n t c e n te r m anager e a rn s a s a t i s f a c t o r y r e t u r n on th e in v e s tm e n t he em ploys, th e n th e company a s a whole sh o u ld a ls o e a rn a s a t i s f a c t o r y r e t u r n. The e x te n t to w hich each o f th e above e v a lu a tiv e t o o l s i s em ployed i n th e a sse ssm e n t o f in v e s tm e n t c e n t e r m anageri a l p e rfo rm an c e i s p ro v id e d by TABLE 8 (page 50) and TABLE 9 (page 51)* These t a b l e s show t h a t a s u b s t a n t i a l num ber o f l a r g e U. S. i n d u s t r i a l f ir m s 97 p e r c e n t u t i l i z e r e t u r n on in v e s tm e n t in e v a lu a tin g m a n a g e ria l seg m en ts. A lthough th e r e l a t e d s t a t i s t i c s f o r th e u se o f th e r e s i d u a l income c o n c e p t 1^ p e r c e n t a re n o t n e a r l y so im p re s s iv e, th e r e a d e r m ust be m in d fu l o f th e f a c t t h a t th e r e s i d u a l income ap p ro ach was v i r t u a l l y u n h e a rd o f j u s t te n y e a rs a g o. A d d itio n a lly, i t sh o u ld be n o te d t h a t o n ly 2 p e r c e n t o f th e firm s w hich employ in v e s tm e n t c e n te r r e s p o n s i b i l i t y do n o t u se e i t h e r form o f e v a lu a tio n, w h ile 13 p e r c e n t o f th e s e firm s u se b o th r e t u r n on in v e s tm e n t and r e s i d u a l income m e a su re s. Due to th e g r e a t e r c u r r e n t im p o rta n c e o f ROI in m a n a g e ria l p e rfo rm an c e e v a lu a tio n, a s i n d ic a t e d by th e above two t a b l e s, th e s e n s i t i v i t y a n a l y s i s in c lu d e d in t h i s s tu d y e m p h asizes th e s e n s i t i v i t y o f ROI o n ly i n i t s t e s t p h a s e s. A c o n te x tu a l e x a m in a tio n o f each e v a lu a tiv e

64 INDUSTRY GROUPING TABLE 8 INVESTMENT CENTER PERFORMANCE EVALUATIVE TOOLS ANALYSIS BY INDUSTRY GROUPING TOTAL INVESTMENT CENTERS WITHIN THE FIRM DOES NOT USE ROI/ RESIDUAL INCOME INVESTMENT CENTER EVALUATIVE TOOLS USES ROI USES RESIDUAL INCOME USES BOTH TOOLS ROI TOTAL 1 FIRMS A p p lia n c e s /E le c tr o n ic s, C h e m ic a ls/p h a rm a c e u tic a ls C om m unications, C o m p u ters/o ffice E quipm ent, F ood /B ev erag es/t o b acco, I n d u s t r i a l E quipm ent..,, L e is u r e /S p o r tin g Goods., P a p e r/p a p e r P r o d u c ts j 15 1 P etro leu m P ro d u c ts /R e fin in g S c ie n tif ic /A e r o s p a c e t* T e x tile s /A p p a r e l V e h ic le s /V e h ic le P a r t s Wood P ro d u c ts /C o n s tru c tio n !5 3 M e ta ls/o th e r I n d u s t r i e s T o ta l Number o f Firm s RESIDUAL INCOME TOTAL FIRMS P e rc e n ta g e R a te s # 2# 84# Vfo # 14# SOURCEi C o rp o ra tio n s re sp o n d in g to q u e s tio n n a ir e, In fo rm a tio n d e riv e d from TABLE 5«o

65 TABLE 9 INVESTMENT CENTER PERFORMANCE EVALUATIVE TOOLS ANALYSIS BY FIRM SIZE FIRM SIZE AT LEAST - LESS THAN TOTAL INVESTMENT CENTERS WITHIN THE FIRM DOES NOT USE ROI/ RESIDUAL INCOME INVESTMENT CENTER EVALUATIVE TOOLS USES ROI USES RESIDUAL INCOME USES BOTH TOOLS ROI TOTAL FIRMS RESIDUAL INCOME TOTAL FIRMS No Minimum - {[5200 M illio n SJ200 M illio n - i5350 M illio n M illio n M illio n M illio n - $ M illio n M illio n - 51 B i l l i o n $1 B i l l i o n B i l l i o n $2 B i l l i o n - No Maximum, T o ta l Number o f Firm s., [ P e rc e n ta g e R a te s ? 2% 84 % [ 97% 14# SOURCEt C o rp o ra tio n s re sp o n d in g to q u e s tio n n a ir e, I n fo rm a tio n d e riv e d from TABLE 6,

66 52 t o o l f o llo w s. RETURN ON INVESTMENT As shown in th e p r e v io u s s e c t i o n, n e a r l y e v e ry m ajo r d e c e n tr a li z e d i n d u s t r i a l firm i n th e U n ite d S t a te s to d a y u t i l i z e s some a d a p ta tio n o f r e t u r n on in v e s tm e n t in th e m easurem ent o f in v e s tm e n t c e n te r m a n a g e ria l p e rfo rm a n c e. I n t h i s r e s p e c t, t h e r e a re b a s i c a l l y two m ajo r form s t h a t ROI can assum e. Each o f th e s e form s i s d e sig n e d to m eet a d i f f e r e n t e v a lu a tiv e n e e d. These a d a p ta tio n s a r e i Cash r e t u r n, w hich i s u se d i n th e e v a lu a tio n o f econom ic p e rfo rm a n c e, and c o n s i s t s o f th e r a t i o o f cash incom e to c ash i n v e s te d i n th e segm ent, and 2. O p e ra tin g r e t u r n, w hich i s u se d i n th e e v a lu a tio n o f se g m e n ta l o p e r a tin g p e rfo rm a n c e, and c o n s i s t s o f th e r a t i o o f o p e r a tin g incom e to o p e r a tin g in v e s tm e n t. T h is stu d y c o n c e rn s i t s e l f o n ly w ith th e l a t t e r form o f r e t u r n on in v e s tm e n t. Thus, th e im p o rta n t t h in g to keep i n mind i s t h a t th e ROI m easure in v o lv e s o p e r a tin g e f f i c i e n c y, n o t econom ic v a lu e and a s su c h, th e in v e s tm e n t b a se sh o u ld c o n s i s t o f th e o p e r a tin g, n o t th e c a sh, v a lu e o f th e a s s e t s em ployed. I n an o v e r a l l s e n s e, FIGURE 2 (page 5 3 ) p r e s e n t s a c o n c e p tu a l scheme i n w hich th e r e l a t i o n s h i p o f f a c t o r s a f f e c t i n g th e d e te r m in a tio n o f l^e dw ard A. R a v e n s c ro ft, "R e tu rn on In v e s tm e n t! th e M ethod to Your N e e d." H arv ard B u sin e ss Review. 38 (M a rc h -A p ril, i ), 9 7. F i t

67 53 o p e r a tio n a l r e t u r n on in v e s tm e n t i s i l l u s t r a t e d. E a rn in g s R a tio O p e ra tin g Income S a le s R e tu rn On In v e stm e n t In v e stm e n t T urnover S a le s In v e s tm e n t Base FIGURE 2 RELATIONSHIP OF FACTORS AFFECTING RETURN ON INVESTMENT As can be se en from FIGURE 2, ROI a s an o p e r a tin g p erfo rm an ce m easure i s a t o o l w hich b r in g s t o g e t h e r i n one r a t i o m ost o f th e d iv e r s e f a c t o r s r e l a t i v e to th e e a rn in g power e x h ib ite d by a segm ent m anager. I t i s a m easure o f " e f f ic ie n c y " to th e e x te n t t h a t t h i s fo rm u la a tte m p ts to r e l a t e seg m en tal p r o f i t ( o u tp u t) to th e in v e s tm e n t employed in e a rn in g t h i s p r o f i t ( i n p u t ). I t i s o b v io u s t h a t th e r e t u r n c o u ld be c a l c u l a t e d sim p ly by d i v id in g o p e r a tin g income by th e in v e s tm e n t b a s e. To do so, how ever, i s to

68 5^ o b sc u re c r i t i c a l f a c t o r s w hich a f f e c t th e o v e r a l l r e t u r n. The e a rn in g s r a t i o com ponent shows th e c o s t - p r i c e r e l a t i o n sh ip and i n d i c a t e s th e s p re a d betw een re v e n u e s and ex p en se s d u rin g th e p e r io d i n q u e s t io n. The in v e s tm e n t tu r n o v e r o r v e l o c i t y component p r o v id e s an i n d i c a t i o n o f m a n a g e m e n ts e f f i c i e n c y i n u s in g th e a s s e t s a t i t s d i s p o s a l to g e n e ra te s a l e s volum e, and in e s s e n c e, shows th e r e l a t i v e e f f i c i e n c y w ith w hich a segm ent u t i l i z e s th e s e r e s o u r c e s i n e a rn in g i t s p r o f i t s. I t sh o u ld be n o te d t h a t n e i t h e r th e e a rn in g s r a t i o n o r th e tu r n o v e r r a t i o a lo n e p r o v id e s an a d e q u a te m easure o f o p e r a tin g e f f i c i e n c y, due to th e f a c t t h a t th e fo rm er ig n o r e s th e u t i l i z a t i o n o f a s s e t s w h ile th e l a t t e r ig n o r e s p r o f i t a b i l i t y on s a l e s. T h e re fo re, b o th r a t i o r e s u l t s m ust be com bined in o r d e r to m easure e f f i c i e n t seg m en tal e a rn in g pow er. R e tu rn on in v e s tm e n t i s a m easure o f " e f f e c t i v e n e s s " to th e e x te n t t h a t th e f i n a l r e t u r n r e s u l t s a r e com pared w ith p r e e s t a b l i s h e d o b j e c ti v e segm ent g o a ls o r t a r g e t r a t e s. The e x te n t t o w hich se g m e n ta l t a r g e t r a t e s a r e em ployed in th e firm s su rv e y ed, and th e c r i t e r i a u se d to d e te rm in e th e s e t a r g e t r a t e s i s shown in TABLE 10 (p ag e 5 5 ) T h is t a b l e i n d i c a t e s t h a t 82 p e r c e n t o f th e firm s u s in g ROI e s t a b l i s h ROI t a r g e t r a t e s. E q u a lly im p o rta n t i s th e f a c t t h a t 83 p e rc e n t o f th e firm s t h a t e s t a b l i s h t a r g e t r a t e s s e t d i f f e r e n t g o a l o b j e c ti v e s f o r d i f f e r e n t in v e s tm e n t c e n te r m an ag ers. Thus, th e u n iq u e n e s s o f one in v e s tm e n t

69 TABLE 10 ANALYSIS OF RETURN ON INVESTMENT EVALUATIVE TOOL: ROI TARGET RATES QUESTIONNAIRE INQUIRY AND TARGET RATE RESPONSE TOTAL FIRMS RETURN ON INVESTMENT TARGET RATES NO PERCENTAGE OF TOTAL TOTAL FIRMS YES PERCENTAGE OF TOTAL Are r e t u r n on in v e stm e n t t a r g e t r a t e s e s ta b lis h e d? # # 209 I f YES, a re th e e s t a b l is h e d ROI t a r g e t r a t e s th e same f o r a l l in v e s tm e n t c e n te r segm ents? # 29 17# 172 TOTAL FIRMS 100# ROI T a rg e t R ate B a s is : C o rp o rate r a t e o f r e t u r n..... C o rp o rate c o s t o f c a p i t a l... I n d u s t r i a l c o n d itio n s..... F u tu re o r b u d g eted p r o f i t... P a s t in v e s tm e n t c e n te r perform ance # 31# 41# # 36# T o ta l Response to I n q u ir y * 180#* 172 SOURCE: C o rp o ra tio n s re sp o n d in g to q u e s tio n n a ir e. R esponse p e rc e n ta g e ex ceed s 100# becau se 75 out o f 172 firm s gave m u ltip le answ ers t o t h i s i n q u ir y.

70 c e n te r v e rs u s a n o th e r ( i. e., s i z e, ag e, c o m p o sitio n, lo c a t i o n, and o p e r a tin g en v iro n m en t) i s a t l e a s t p a r t i a l l y acknow ledged. O th er d i f f e r e n c e s such a s grow th r a t e s and v a ry in g d e g re e s o f r i s k a re more d i f f i c u l t to a s c e r t a i n and, t h e r e f o r e, a r e o f te n n o t acknow ledged i n th e m easu rement a t a l l. Thus, a l l f o r c e s a f f e c t i n g seg m en tal a c t i v i t y a re n o t p e rc e iv e d w ith e q u a l c l a r i t y, n o r do th e s e f o r c e s, even when re c o g n iz e d, alw ays work in th e same d i r e c t i o n o r p a t t e r n. As su c h, even w ith th e u se o f d i f f e r e n t i a l t a r g e t r a t e o b j e c t i v e s, ROI a s a m easure o f m a n a g e ria l e f f e c tiv e n e s s i s o n ly r e a l i s t i c a l l y e f f e c t i v e i f th e f a c t o r s c o n tr i b u ti n g t o in v e s tm e n t c e n te r u n iq u e n e ss a r e re c o g n iz e d, u n d e rs to o d, and p ro v id e d f o r. L a s tly, i t sh o u ld be n o te d t h a t th e v a s t m a j o r it y o f firm s u se m u ltip le c r i t e r i a in e s t a b l i s h i n g segm ent m anagement t a r g e t g o a ls. I n an o v e r a l l s e n s e, and i n l i n e w ith th e Du P ont system (a s ROI i s f r e q u e n t ly n am ed ), i t a p p e a rs t h a t seg m en tal e f f e c t i v e n e s s i s p r i m a r il y ju d g ed by th e segm ent m a n a g e r's a b i l i t y to s a t i s f y a p r o j e c te d ROI g o a l, n o t by h i s a b i l i t y to l i v e w ith in s e t b u d g e t c o n s t r a i n t s. 20 For exam ple, i n th e s h o r t ru n, a segm ent m anager may in f lu e n c e th e e a rn in g s r a t i o o r in v e s tm e n t tu r n o v e r i n a num ber o f w aysi The e a rn in g s r a t i o can be in f lu e n c e d by re d u c in g c o s t s o r by i n c r e a s in g s a l e s volume (an d t h e r e f o r e p r o f i t s ) th ro u g h a 2 jo h n D earden, "Case A g a in st ROI C o n tr o l," H arvard B u sin e ss R eview, 47 (M ay-june, I ), 125.

71 m o d if ic a tio n o f th e s a l e s p r i c e and m a rk e tin g s t r a t e g y w ith in th e c o n s t r a i n t s im posed "by c o m p e titio n. The t u r n o v e r r a t i o can be in f lu e n c e d by w orking th e c a p i t a l em ployed more i n t e n s e l y, by c o n v e rtin g p a r t o f th e p l a n t to o th e r p ro d u c t l i n e s ( th e r e b y s p re a d in g th e in v e s tm e n t b a s e ), o r by sim p ly e lim in a tin g p a r t o f th e in v e s tm e n t b a se i t s e l f. 2 ^ In t h i s l a t t e r c a s e, i f a segm ent m anager*s r e t u r n g o a l i s 5 p e rc e n t a f t e r t a x e s, a r e d u c tio n o f one d o l l a r i n th e in v e s tm e n t b a se h a s th e same im p act on p e rfo rm an c e a s a 1 0 -c e n t s a v in g s i n c o s t o r a 1 0 -c e n t in c r e a s e i n p r o f i t s from added re v e n u e s (assu m in g a 50 p e r c e n t ta x b r a c k e t ). N a tu r a lly, some o f th e d e c is io n a c t io n s s t a t e d above have r e c i p r o c a l e f f e c t s on b o th e le m e n ts o f th e ROI e q u a tio n a s w e ll a s lo n g -te rm i m p lic a tio n s f o r b o th th e segm ent and th e company a s a w hole. T h e re fo re, p r i o r to im p lem en tin g any ch an g es, i t i s im p o rta n t t h a t f u l l a p p r a i s a l o f each f a c t o r on a s h o r t and lo n g -te rm b a s i s be i n i t i a t e d. As a m easure o f in v e s tm e n t c e n te r m a n a g e ria l p e r f o r m ance, r e t u r n on in v e s tm e n t i s s a id to p o s s e s s th e fo llo w - in g s t r e n g th s PP 1. ROI i s a com prehensive m easu re, in f lu e n c e d by 2 *I b i d., p. 126; see a ls o D udley S te w a rt, "The S earch f o r a B u sin e ss S u rv iv a l C o e f f ic ie n t! The R ole o f ROI," The J o u r n a l o f A ccountancy, 123 ( A p r il, 1967)1 62 and H arvey 0. E dson, "R etu rn on In v estm e n t* A n a ly s is by S y n th e s is," The Ohio C e r t i f i e d P u b lic A c c o u n ta n t, S p rin g, 19o9» p. 76.?P R obert N. A nthony, Jo h n D earden, and R ic h a rd F. V a n c il, Management C o n tro l S y stem s, ( r e v. e d.; I l l i n o i s! R ic h a rd D. I rw in, I n c., 1972), p. 337.

72 58 e v e r y th in g t h a t h a s o c c u rre d w hich a f f e c t s th e f i n a n c i a l s t a t u s o f a seg m en t. F u r th e r, ROI i s a means o f m aking th e g o a ls o f th e segm ent m anager c o n g ru e n t w ith th o s e o f th e o v e r a l l c o rp o r a tio n! t h a t i s, i f th e segm ent m anager m axim izes h i s r e t u r n g o a l, i t sh o u ld a u to m a tic a lly fo llo w t h a t th e t o t a l company a ls o m axim izes i t s r e t u r n. 2. ROI p r o v id e s an in c e n ti v e t o u se e x i s t i n g a s s e t s to t h e i r f u l l e s t and to a c q u ir e a d d i t i o n a l r e s o u r c e s o n ly when th e y a re l i k e l y to i n c r e a s e th e r e t u r n r a t i o. In o th e rw o rd s, ROI m easu res how w e ll th e segm ent m anager u se s h i s p r o p e r ty and r e s o u r c e s to g e n e r a te segm ent p r o f i t s. Thus, by in c lu d in g new in v e s tm e n ts i n th e p erfo rm an ce b a s e, th e in v e s tm e n t c e n t e r ROI w i l l be a u to m a tic a lly a f f e c t e d in an a d v e rs e way when a c t u a l p r o f i t s f a i l to m eet th o s e l e v e l s o r i g i n a l l y p r o j e c t e d. 3. ROI i s a common d e n o m in a to r. As su ch, r e s u l t i n g segm ent m anager p e rfo rm an c e can, i f d e s ir e d, be compared w ith o th e r p e rfo rm an c e r a t i n g s w ith in th e company. A lso, th e s i g n i f i c a n c e o f ROI i s e a s i l y u n d e rs to o d. For exam ple, i f a segm ent m anager e a rn s 3 p e r c e n t a f t e r t a x e s, th e firm as a w hole c o u ld r e a l i z e more th ro u g h an e x te r n a l i n v e s t ment i n b o n d s. C o n v e rse ly, a segm ent m anager e a rn in g 30 p e r c e n t a f t e r t a x e s i s e a rn in g a g r e a t e r r e t u r n th a n co u ld be r e a l i z e d on a lm o st any ty p e o f a l t e r n a t i v e u se o f fu n d s. In s h o r t, ROI i s suppose t o r e s u l t in each segm ent m anager o p tim iz in g h i s r e t u r n w hich sh o u ld, i n tu r n, r e s u l t

73 59 i n an optimum t o t a l company r e t u r n. S in ce a m anager i s e v a lu a te d on h i s a b i l i t y to o p tim iz e ROI, he w i l l o b v io u s ly be m o tiv a te d to do so. The e x te n t to w hich th e above ROI a d v a n ta g e s s t i l l e x i s t due to t h i s m o tiv a tio n te n d e n c y, how ever, i s q u e s tio n a b le i n view o f R O I's fo llo w in g weakn e s s e s i 1. The p rim a ry w eakness a s s o c i a t e d w ith th e r e t u r n on in v e s tm e n t m easure i s t h a t i t fo c u s e s a t t e n t i o n on th e m a x im iz a tio n o f a r a t i o r a t h e r th a n on an im provem ent in a b s o lu te p r o f i t s.a s shown i n FIGURE 3 im provem ent in a se g m e n t's ROI can be i n v e r s e l y r e l a t e d t o th e a s s o c ia te d im provem ent in t o t a l d o l l a r p r o f i t s. I n o th e rw o rd s, th e segm ent p o s s e s s in g th e h ig h e s t ROI i s n o t n e c e s s a r i l y th e m ost p r o f i t a b l e segm ent w ith in a company. In v e s tm e n t C e n te rs T o ta l Segment A Segment B Company In v e stm e n t B a se $ 1,000 $5,000 $6,000 P r o f i t E a rn e d R e tu rn on In v e stm e n t... 20# 15# 16# FIGURE 3 CONFLICT BETWEEN ROI AND PROFIT PERFORMANCE In th e above i l l u s t r a t i o n th e c o n f l i c t a r i s e s b e c a u se d e s p ite th e f a c t t h a t Segment A 's ROI ex ceed s t h a t f o r Segment B, Segment A 's p r o f i t p e rfo rm an c e i s lo w e r. ^ H a r o l d B ierm an, J r., "Problem s in C om putation and Use o f ROI," N.A.A. B u l l e t i n. 39 (Decem ber, 1957), 81.

74 Thus, i n t h i s c a se, r e t u r n on in v e s tm e n t i s b e in g m axim ized a t th e p o t e n t i a l s a c r i f i c e o f t o t a l p r o f i t o p tim iz a tio n. In a d d itio n to th e c o n f l i c t s i t u a t i o n c i t e d ab ove, em phasis on r a t i o a s opposed to d o l l a r p r o f i t im provem ent a ls o te n d s to r e t a r d i n c e n ti v e f o r grow th and e x p a n sio n. In o th e rw o rd s, one o f th e e a s i e s t ways to in c r e a s e ROI o v e r th e s h o r t ra n g e i s t o c o n ta in o p e r a tio n s to t h e i r p r e s e n t c a p a c i t i e s. L a s tly, th e s i t u a t i o n i n which th e m axim izat i o n o f ROI and th e m a x im iz a tio n o f o p e r a tin g p r o f i t s h o ld s an in v e r s e r e l a t i o n s h i p g e n e r a l l y o c c u rs when in v e s tm e n t c e n te r m anagement h a s d i s c r e t i o n a r y c o n tr o l o v e r a s i g n i f i c a n t p o r t io n o f t h e i r in v e s tm e n t b a s e. Conv e r s e ly, i f segm ent a s s e t s a re com m itted o r r e l a t i v e l y fix e d in n a tu r e o v e r th e s h o r t ru n, th e m ax im iz a tio n o f o f th e ROI r a t i o would s im u lta n e o u s ly a ls o r e s u l t i n th e m ax im iz a tio n o f a b s o lu te d o l l a r p r o f i t s. 2. A nother w eakness i n ROI, c lo s e ly r e l a t e d to th e above, i s t h a t a segm ent e a rn in g a h ig h e r ROI th a n th e c o r p o r a tio n a s a whole i s d is c o u ra g e d from e n te r in g an in v e stm e n t s i t u a t i o n w here th e e x p e c te d ROI f a l l s i n betw een. F or exam ple, i n th e s i t u a t i o n i l l u s t r a t e d in FIGURE 3» Segment A 's m anagement would be h ig h ly r e l u c t a n t to a c c e p t any p ro p o s a l y i e l d i n g an ROI o f l e s s th a n 20 p e r c e n t, y e t f o r th e firm a s a w hole, any p r o p o s a l t h a t y i e l d s a r e t u r n g r e a t e r th a n 16 p e r c e n t sh o u ld be u n d e r ta k e n w ith in th e seg m en ts. In th e s i t u a t i o n d e s c r ib e d

75 61 in c o n s is te n c y o r la c k o f co n g ru en cy e x i s t s betw een segment a l and firm o b j e c t i v e s. C o rp o ra te s u b o p tim iz a tio n may r e s u l t a s a consequence o f t h i s c o n f l i c t, b e c a u se m o tiv a t i o n and e v a lu a tio n a re two s i d e s o f th e same c o in. I n e s s e n c e, a segm ent m anager w i l l be m o tiv a te d to o p tim iz e th e f a c t o r s on w hich he i s to be e v a lu a te d. To i l l u s t r a t e su b o p tim a l c o n f l i c t, c o n s id e r th e fo llo w in g t r u e s i t u a t i o n i A segm ent m anager sc ra p p e d some equipm ent t h a t he was n o t p r e s e n t l y u s in g i n o rd e r to re d u c e th e e f f e c t o f t h i s re s o u rc e i n h i s in v e s tm e n t b a s e. L a te r, when t h i s equipm ent was n eeded in o p e r a tio n s,, th e segm ent m anager sim p ly p u rc h a se d new e q u ip m e n t.2^ Thus, th e above s i t u a t i o n shows t h a t i n an a tte m p t to im prove th e s h o r t - r u n m easure o f ROI, a segm ent m anager may be m o tiv a te d to i n i t i a t e d e c is io n a c t io n s c o n tr a r y to th e com pany's lo n g - r u n i n t e r e s t s. 3. The l a s t m ajo r w eakness in ROI stem s from th e f a c t t h a t ROI s i m p l i f i e s a v e ry com plex d e c is io n p r o c e s s. In o th e rw o rd s, ROI i s to o sim p le a r u l e on w hich to b a se th e a p p r o p r ia te t r a d e o f f betw een p r o f i t s and in v e s tm e n t. A d d itio n a lly, w ith ROI, th e same r e t u r n r a t e i s a p p lic a b le to a l l a s s e t s w ith in a g iv e n segm ent. T his c r e a t e s a problem b e c a u se d i f f e r e n t ty p e s o f a s s e t s m ight r e a l i s t i c a l l y be e x p e c te d to e a rn d i f f e r e n t r a t e s o f r e t u r n. F u rth e rm o re, a lth o u g h th e t r a d e o f f betw een in v e s tm e n t and p r o f i t i s a c o n s ta n t f a c t o r w ith in any g iv e n segm ent, among ^ B r u c e D, H enderson and Jo h n D earden, "New System f o r D iv is io n a l C o n tr o l," H arv ard B u sin e ss R eview, kk (Septem ber- O cto b er, 1966), 150.

76 62 d i f f e r e n t segm ents t h i s t r a d e o f f w i l l d i f f e r i f t h e i r p r o f i t g o a ls d i f f e r. C o n se q u e n tly, i d e n t i c a l a s s e t s l o c a t ed in d i f f e r e n t segm ents c o u ld he s u b je c t t o v a ry in g r e t u r n r a t e s. I n summary, i n o rd e r to manage i n t e g r a t e d a s s e t s s u c c e s s f u ll y, a firm m ust a c h ie v e a b a la n c e o f r e s o u r c e s among i t s i n t e r n a l segm ents, a b a la n c e t h a t m axim izes s h o r t- r u n p r o f i t s b u t does n o t s a c r i f i c e t h e i r lo n g -te rm s t a b i l i t y. From th e f o re g o in g, i t w ould seem t h a t th e ROI m easure, i n i t s p r e s e n t form, f a i l s to a cc o m p lish t h i s g o a l. RESIDUAL INCOME P e rh a p s th e m ost im p o rta n t a d a p ta tio n o f th e ROI c o n c e p t h a s been th e r e s i d u a l incom e a p p ro a c h, d ev elo p ed by 26 th e G en eral E l e c t r i c Company i n th e 's. U sing t h i s m ethod o f e v a lu a tio n, in v e s tm e n t c e n te r m a n a g e ria l p e r f o r mance i s m easured a s se g m en tal a c t u a l p r o f i t s m inus a p r e s c r i b e d p e rc e n ta g e ch arg e f o r th e r e s o u r c e s th e segm ent m anager em ploys in h i s o p e r a tio n s. C o n c e p tu a lly, th e r e l a t io n s h ip o f f a c t o r s a f f e c t i n g th e d e te rm in a tio n o f r e s i d u a l income i s i l l u s t r a t e d i n FIGURE k (page 6 3 ). 2 A nthony, D earden, and V a n c il, op. c i t., p. 3^6. 26 See th e "G e n era l E l e c t r i c Company" c a se i n i b i d. A lthough r e s i d u a l incom e was d e v elo p ed i n th e 1950's, t h i s c o n c e p t was n o t w id e ly u se d a s a p e r f o r mance m easure u n t i l a b o u t 10 y e a rs ag o.

77 63 O p e ra tin g Income R e s id u a l Income C a p ita l o r I n t e r e s t Charge In v e stm e n t Base C a p ita l o r I n t e r e s t R ate FIGURE 4 RELATIONSHIP OF FACTORS AFFECTING RESIDUAL INCOME * U n lik e ROI, which i s a r e l a t i v e m easu re, r e s i d u a l incom e i s a m easure in a b s o lu te d o l l a r s. T h is em phasis to w ard a num ber i n s t e a d o f a r a t i o p ro v id e s a q u a l i t y t h a t a id s i n overcom ing some o f th e ROI l i m i t a t i o n s p r e v io u s ly d e s c r ib e d. As an exam ple, c o n s id e r th e s i t u a t i o n o u tlin e d in FIGURE 3 (page 59) and i n q u ir e i Which segm ent m anager h as b een th e m ost s u c c e s s f u l i n h i s o p e r a tin g p erfo rm an c e? In a n sw e rin g t h i s q u e s tio n, a c r i t e r i o n m ust be e s ta b lis h e d. I f a b s o lu te p r o f i t i s th e t e s t, th e answ er i s Segment B, how ever, i f r a t e o f r e t u r n i s th e t e s t, th e n Segment A i s th e a n sw e r. I n a c t u a l i t y, th e r e s o l u t i o n a s to who h a s been th e m ost s u c c e s s f u l m anager i s n o t d e te rm in a b le w ith o u t c o n s id e r a tio n o f th e r e q u ir e d minimum e a rn in g s r a t e t h a t j u s t i f i e s th e u se o f re s o u rc e f a c i l i t i e s i n each segm ent.

78 6k Assum ing t h a t th e f i r m 's w e ig h te d a v e ra g e c o s t o f c a p i t a l r e p r e s e n t s t h i s minimum e a rn in g s r a t e, FIGURE 5 r e s t r u c t u r e s th e in fo r m a tio n p r e v io u s ly shown i n FIGURE 3 i n o rd e r to h e lp r e s o lv e th e management s u c c e s s e v a lu a tio n c o n f l i c t. The r e s u l t s shown in FIGURE 5 a re b a se d on th e u se o f r e s i d u a l income (a s opposed t o FIGURE 3 's ROI) a s th e s u c c e s s c r i t e r i o n and c o s t o f c a p i t a l a s th e c h a rg in g r a t e. In v e stm e n t C e n te rs T o ta l Segment A Segment B Company In v e s tm e n t B a s e...$ 1,0 0 0 $5»000 $ 6,0 0 0 P r o f i t E a rn e d R e s id u a l Income (L oss) Assum ing a C ost o f C a p ita l R ate o f j 1 2 ^ Q o 1 5 Q $ * (100) ( 70) FIGURE 5 RESOLUTION OF CONFLICT BETWEEN ROI AND PROFIT RESULTS THROUGH RESIDUAL INCOME EVALUATION FIGURE 5 i l l u s t r a t e s t h a t w h ile th e v e n tu re w hich g iv e s th e h ig h e s t r a t e o f r e t u r n can he p o in te d to u n e q u iv o c a lly, th e r e i s no sim p le answ er to th e q u e s tio n o f w hich o f th e s e in v e s tm e n t c e n te r m anagers i s more s u c c e s s f u l i n te rm s o f r e s i d u a l income performancewhile Segment B s m anagement i s more s u c c e s s f u l a t lo w e r c h a rg in g r a t e s, Segment A 's management i s more s u c c e s s f u l a t h ig h e r c h a rg in g r a t e s. A m ere com parison o f r a t e s o f r e t u r n ( a s i l l u s t r a t e d i n ^ S o lo m o n s, P» c i t,, p p *

79 65 FIGURE 3) o b sc u re s t h i s f a c t. The p rim a ry re a s o n, how ever, f o r p r e f e r i n g a segm ent m anager to m axim ize r e s i d u a l incom e r a t h e r th a n ROI i s t h a t th e l a t t e r m easure may cau se th e m anager t o be u n w ill i n g to expand in v e s tm e n t i f i t w i l l lo w e r h i s se g m e n t's a v e ra g e r e t u r n r a t e, even though th e in c re m e n ta l d o l l a r r e t u r n from d o in g so i s i n e x c e ss o f c o s t. Assuming d i s c r e t io n a r y a u t h o r i t y o v e r a se g m e n t's in v e s tm e n t b a s e, th e segm ent m anager u n d o u b te d ly w i l l have an u p p e r c e i l i n g to h i s pow er to expend fu n d s b u t no lo w er l i m i t, a s lo n g a s th e d o l l a r r e t u r n e x ceed s th e c o s t w hich j u s t i f i e s th e u se o f th e fu n d s i n q u e s tio n. I f, how ever, fu n d s a re f ix e d i n s t e a d o f d i s c r e t i o n a r y, i t w ould be j u s t a s s a t i s f a c t o r y to have th e segm ent m anager m axim ize ROI, a s t h i s would be e q u iv a le n t to h i s m axim izing t o t a l a b s o lu te d o l l a r s a s n 28 w e l l. B e fo re th e m easure o f r e s i d u a l income can be determ in ed, two m ajo r q u e s tio n s m ust be answ ered! 1. How i s th e in v e s tm e n t b a se d e fin e d and what i s i t s co m p o sitio n? 2. What b a s i s i s u se d f o r e s t a b l i s h i n g th e i n t e r e s t o r c a p i t a l in v e s tm e n t c h a rg in g r a t e? The f i r s t q u e s tio n would have to be answ ered even i f ROI r a t h e r th a n r e s i d u a l income was b e in g u se d a s th e e v a lu a tio n c r i t e r i o n. As such, d is c u s s io n o f in v e s tm e n t ^ Ib id,, pp. 63-6*1.

80 b a se scope and c o m p o s itio n w i l l be d e f e r r e d u n t i l C h a p te r 5. The second q u e s tio n r e l a t i v e to c h a rg in g r a t e s does n o t a r i s e w ith th e r e t u r n on in v e s tm e n t c a l c u l a t i o n b u t i s a key f a c t o r i n th e m easurem ent o f r e s id u a lin c o m e. I n t h i s r e s p e c t, TABLE 11 (page 6 7 ) shows th e r e s u l t s o f p e r t i n e n t q u e s tio n s r e g a r d in g r e s i d u a l incom e t h a t w ere p o se d t o th e c o rp o r a tio n s re s p o n d in g to th e su rv e y u se d in t h i s s tu d y. T his t a b l e shows t h a t th e v a s t m a j o r it y o f firm s u s in g r e s i d u a l incom e e s t a b l i s h t h e i r c h a rg in g r a t e s u s in g a s a g u id e e i t h e r th e f i r m 's c o s t o f d e b t--3 9 p e r c e n t o r th e f i r m 's w e ig h te d a v e ra g e c o s t o f c a p i t a l 33 p e r c e n t. T h is l a t t e r b a s i s seems t o be p a r t i c u l a r l y a p p r o p r ia te s in c e i t would e n co u rag e an in v e s tm e n t c e n te r m anager to a c c e p t a l l m a rg in a l r e in v e s tm e n t o r new p r o p o s a ls fa v o r a b le t o th e company a s a w h o le. At th e same tim e, any i n e f f i c i e n t o r u n p r o f i t a b l e u se o f c o rp o r a te r e s o u r c e s w ould be p e n a liz e d. I n a d d it i o n, a firm c h a rg in g r a t e b a s i s ( a s opposed to a segm ent r a t e b a s is ) i s u se d p ro b a b ly b e ca u se d i v e r s i f i e d c o r p o r a tio n s w i l l se ek to re d u c e th e r i s k s a s s o c ia te d w ith i t s i n d iv i d u a l in v e s tm e n t c e n te r segm ents th ro u g h a r i s k o f f s e t t i n g p r o c e s s. For t h i s re a s o n, seg m en tal r i s k i s n o t a s s e s s e d by v iew in g each segm ent in i s o l a t i o n. The re s p o n s e to th e second q u e s tio n in TABLE 11 te n d s to b e a r o u t t h i s c o n te n tio n, i n t h a t o n ly 10 p e rc e n t o f th e re s p o n d in g firm s v a ry t h e i r c h a rg in g r a t e from one in v e s tm e n t c e n te r to a n o th e r. R e g a rd le s s o f

81 TABLE 11 ANALYSIS OF RESIDUAL INCOME EVALUATIVE TOOL: CAPITAL (INTEREST) CHARGE RATE INDEX RESIDUAL INCOME CHARGE RATE INDEX QUESTIONNAIRE INQUIRY AND CHARGE RATE INDEX RESPONSE TOTAL FIRMS NO PERCENTAGE OF TOTAL TOTAL FIRMS YES PERCENTAGE OF TOTAL TOTAL FIRMS 100# Are d i f f e r e n t c a p i t a l ( i n t e r e s t ) charge r a t e s a p p lie d to d i f f e r e n t c la s s e s o f a s s e t s? S Are d i f f e r e n t c a p i t a l ( i n t e r e s t ) charge r a t e s e s ta b lis h e d f o r each in v e stm e n t c e n te r segm ent? 28 90? C r i t e r i a f o r Charge R atei S egm ent's o v e r a ll e a rn in g s r a t e.... F irm 's o v e r a ll e a rn in g s r a t e T a rg e t E a rn in g s r a t e... F irm 's w eig h ted av erag e c o s t o f c a p i t a l F irm 's c o s t o f d e b t.....,... O ther c r i t e r i a t Ur # T o ta l R esponse to I n q u ir y SOURCEi C o rp o ra tio n s re s p o n d in g to q u e s tio n n a ir e.

82 th e c h a rg in g c r i t e r i a u s e d, how ever, th e r a t e e s t a b l i s h e d sh o u ld be k e p t low i n o r d e r to a v o id some o f th e same p i t f a l l s p r e v i o u s ly a t t r i b u t e d t o ROI. One f u r t h e r o b s e rv a t i o n n e e d s to be made r e l a t i v e to TABLE 1 1 i I t was s u r p r i s i n g to n o te t h a t 9^ p e r c e n t o f th e re s p o n d in g firm s a p p ly th e same c h a rg in g r a t e t o d i f f e r e n t c l a s s e s o f a s s e t s w ith in a segm ent. I t w ould a p p e a r t h a t th e s e f irm s a re im p ly in g t h a t a l l a s s e t s sh o u ld be r e q u ir e d to e a rn th e same p e rc e n ta g e r e t u r n, a w eakness t h a t was d is c u s s e d e a r l i e r i n th e a n a l y s i s o f ROI. I t i s q u i t e p o s s i b l e, how ever, t h a t th e s e com panies do d i f f e r e n t i a t e betw een a s s e t c h a r a c t e r i s t i c s th ro u g h th e e s ta b lis h m e n t o f d i f f e r e n t i a l d o l l a r r e s i d u a l incom e t a r g e t o b j e c t i v e s, b u t th e e x te n t to w hich t h i s c o m p en satin g f a c t o r e x i s t s i s unknown b e c a u se a q u e s tio n o f t h i s ty p e was n o t in c lu d e d i n th e s u rv e y, and th e l i t e r a t u r e on th e r e s i d u a l incom e t o p ic a r e a i s e x tre m e ly v a g u e. From th e fo re g o in g d is c u s s io n, i t i s c l e a r t h a t some o f th e w eak n esses p r e v io u s ly a t t r i b u t e d to th e u s e o f ROI a re r e s o l v a b l e o r a t l e a s t m inim ized th ro u g h th e u se o f r e s i d u a l incom e. The s t r e n g th s m ost commonly a s s o c i a t e d w ith th e u se o f r e s i d u a l incom e a re a s fo llo w s 29 j 0hn J. M a u rie l and R o b ert N. A nthony, "M ise v a lu a - t i o n o f In v e s tm e n t C e n te r P e rfo rm a n c e, H arv ard B u sin e ss R eview, ^4 (M a rc h -A p ril, 1966), 10*1-; see a ls o E l i o t T erb o rg h, " E v a lu a tio n o f In v e s tm e n t C e n te r P e r fo r m a n c e," Management A c c o u n tin g, 50 (M arch, 1969), 50 and D earden, "Case A g a in st ROI C o n tr o l," op. c i t., p. 130.

83 1. The p rim a ry a d v an tag e o f r e s i d u a l incom e i s t h a t t h i s m easure fo c u s e s a t t e n t i o n on a d o l l a r incom e f i g u r e 69 r a t h e r th a n on a r a t i o. S in ce th e segm ent m anager i s now lo o k in g a t th e a b s o lu te s i z e o f h i s incom e, i t w ould alw ays be to h i s a d v an tag e t o e n t e r a v e n tu re i f he c o u ld e x p e c t to e a rn a d o l l a r r e t u r n s u f f i c i e n t to more th a n o f f s e t th e c a p i t a l ch arg e t h a t would be l e v i e d. U n lik e w ith th e u se o f ROI, th e d e c is io n c r i t e r i a s t a t e d above w ould r e l a t e to b o th h ig h and low e a r n in g in v e s tm e n t c e n t e r s, th e r e b y a v o id in g th e p ro b lem t h a t may o c cu r when a segm ent h a s a v e ry h ig h ROI. A lso, em phasis on a d o l l a r f i g u r e makes u se o f th e r e s i d u a l income t o o l e a s i e r to u n d e rs ta n d b ecau se th e segm ent m anager i s a sk e d to m axim ize a num ber r a t h e r th a n a r a t i o. F u rth e rm o re, t h i s a b s o lu te n a tu r e p o s s e s s e d by r e s i d u a l incom e f a c i l i t a t e s b u d g e tin g, i n t h a t a t a r g e t g o a l f o r r e s i d u a l incom e d o l l a r s can be in c lu d e d a s an i n t e g r a l p a r t o f th e seg m en t s p r o f i t b u d g et pro g ram. 2. An a d d i t i o n a l s t r e n g th a s s o c i a t e d w ith r e s i d u a l income i s t h a t t h i s t o o l r e n d e r s a g r e a t d e a l o f f l e x i b i l i t y in t h a t th e r a t e a s s e s s e d can be v a r ie d from segm ent to segm ent o r a c c o rd in g to th e ty p e o f a s s e t s com posing th e in v e stm e n t b a se i n o r d e r to em phasize c e r t a i n c o rp o r a te o b j e c t i v e s. F or exam ple, th e s h o r t- te r m m a rg in a l b o rro w in g r a t e co u ld be u se d a s th e c h a rg in g f a c t o r f o r i n v e n t o r i e s w h ile th e lo n g -te rm c o s t o f c a p i t a l r a t e co u ld be u se d when d e te rm in in g th e c h a rg in g f a c t o r f o r f ix e d a s s e t s. F u r th e r m ore, d i f f e r e n t r a t e s can a ls o be u se d f o r d i f f e r e n t ty p e s

84 70 o f f ix e d a s s e t s i n o r d e r t o r e f l e c t v a ry in g d e g re e s o f a s s o c ia te d r i s k. T h e re fo re, u n l ik e in th e ROI m easu re, i d e n t i c a l a s s e t s lo c a te d in d i f f e r e n t in v e s tm e n t c e n t e r s can a l l be c h a rg e d w ith th e same p e rc e n ta g e r a t e i n o r d e r to m a in ta in d i s c r e t i o n a r y d e c is io n c o n s is te n c y among th e segm ent m an a g ers. Of c o u rs e, i n TABLE 1 1 's s u rv e y r e s u l t s, i t was r e v e a le d t h a t no more th a n 10 p e r c e n t o f th e firm s u s in g r e s i d u a l incom e v a ry th e in v e s tm e n t b a se c h a rg in g r a t e i n any o f th e ab o v e-m en tio n ed w ays. I n view o f t h i s f a c t, i t w ould a p p e a r t h a t few c o r p o r a tio n s r e a l i z e th e f l e x i b i l i t y a f f o r d e d by th e r e s i d u a l incom e m e a su re. A more im p o rta n t c o n s id e r a tio n i s t h e co nsequence t h a t few c o r p o r a tio n s end up h a v in g a p e rfo rm an c e m easurem ent s y s tem t h a t i s c o n s i s t e n t w ith th e d e c is io n r u l e s t h a t a f f e c t th e p la n n in g p ro c e s s i n th e a c q u s i t io n, u t i l i z a t i o n, and d is p o s a l o f a s s e t r e s o u r c e s. D e sp ite th e above somewhat im p re s s iv e a d v a n ta g e s, th e r e s i d u a l income m easure s t i l l p o s s e s s e s th e fo llo w in g w eak n essesi 1. Once r e s i d u a l income i s d e te rm in e d f o r an i n v e s t ment c e n te r m anager, th e p e rfo rm a n c e r e s u l t s c a n n o t be u se d f o r any ty p e o f in te r s e g m e n ta l co m p ariso n, s in c e a b s o lu te d o l l a r am ounts a re n o t s u b je c t t o m e a n in g fu l d i r e c t c o m p a riso n s. I n a d d it i o n, when a firm u t i l i z e s b o th ROI and r e s i d u a l incom e and th e p e rfo rm a n c e r e s u l t s c o n f l i c t (a s p r e v io u s ly i l l u s t r a t e d in FIGURES 3 and 5 on

85 p a g es 59 and 6 4 ), w hich t o o l i s c o n s id e re d a s th e more 71 r e l i a b l e p erfo rm an ce m easu re? Due t o th e c o m p a rativ e a b i l i t y o f th e ROI r a t i o, v e ry o f te n th e r e s i d u a l incom e r e s u l t s a re c o n s id e re d a s s u b o r d in a te d t o ROI when c o n f l i c t s i t u a t i o n s a r i s e. In th e p r e s e n t q u e s t io n n a ir e s tu d y, 13 p e r c e n t o f th e firm s re s p o n d in g to th e su rv e y u se a comb i n a t i o n o f b o th t o o l s In t h e i r e v a lu a tio n e f f o r t s, so th e above o b s e r v a tio n assum es some d e g re e o f im p o rta n c e. 2. In th e c ase o f r e s i d u a l incom e, a s w ith ROI, th e problem o f i d e n t i f y i n g in v e s tm e n t b a se scope and com posit i o n rem a in s a fo rm id a b le t a s k. O b v io u sly, th e n, th e problem o f p o t e n t i a l s u b o p tim iz a tio n h a s n o t been c o m p le te ly r e s o lv e d th ro u g h th e u s e o f th e r e s i d u a l incom e m ea su re. OTHER FORMS OF INVESTMENT CENTER MANAGERIAL EVALUATION I n s te a d o f a tte m p tin g t o combine p r o f i t a b i l i t y and in v e s tm e n t i n to a s in g le m easure o f e f f e c t i v e n e s s, some firm s r e s o r t to a s e p a r a te a n a l y s i s o f th e s e two f a c t o r s th ro u g h a c o m b in atio n o f a c t u a l v e rs u s b u d g e t co m p ariso n s and p o s t- c o m p le tio n a u d i t s. O th er firm s u t i l i z e d i f f e r e n t t o o l s e n t i r e l y i n e v a lu a tin g in v e s tm e n t c e n t e r m anagem ent. Most firm s, how ever, u se ROI o r r e s i d u a l incom e b u t s u p p le m ent th e s e m easurem ent r e s u l t s w ith a d d i t i o n a l form s o f e v a lu a tio n. The e x te n t to w hich o th e r form s o f e v a lu a tio n a re u se d, e i t h e r i n re p la c e m e n t o f o r i n a d d it i o n t o ROI and r e s i d u a l incom e, i s sum m arized i n TABLE 12 (p ag e 7 2 ).

86 TABLE 12 OTHER TOOLS USED IN REPLACEMENT OF OR IN ADDITION TO ROI AND RESIDUAL INCOME IN THE EVALUATION OF INVESTMENT CENTER MANAGEMENT OTHER TOOLS USED QUESTIONNAIRE INQUIRY AND NATURE OF TOOL RESPONSE TOTAL FIRMS NO PERCENTAGE OF TOTAL TOTAL FIRMS YES PERCENTAGE OF TOTAL TOTAL FIRMS 100# Are perform ance m easures o th e r th a n r e t u r n on in v e stm e n t and r e s i d u a l income u se d to e v a lu a te seg m en tal management? # # 215 N atu re o f O ther T ools Usedj C u rre n t compared w ith p r i o r p e rio d * s p e rfo rm a n c e.. P r o f i t m argin and grow th o f sam e R etu rn on S a l e s... A c tu al v e rs u s p re d e te rm in e d perform ance g o a l. *. E f f ic ie n c y o f re s o u rc e u t i l i z a t i o n... Net cash f l o w... Net p r e s e n t v a lu e (o r p r o j e c t b a s i s )... O ther form s o f e v a l u a t i o n if if 13# 23# 3if# 35# 28# 5# if# if# 109 T o ta l Response to I n q u ir y * lif6#* 109 SOURCEi C o rp o ra tio n s re sp o n d in g to q u e s tio n n a ir e. Response p e rc e n ta g e exceeds 100# b ecau se 20 o u t o f 109 firm s gave m u ltip le answ ers to t h i s i n q u ir y.

87 73 TABLE 12 shows t h a t 51 p e r c e n t o f th e firm s re s p o n d in g t o t h i s in q u ir y do n o t u se ROI o r r e s i d u a l incom e i n i s o l a t i o n. Some firm s even u se m u ltip le a u x i l i a r y m easu res to s u p p le m ent ROI and r e s i d u a l incom e r e s u l t s. The d i s t u r b i n g f a c t, how ever, i s t h a t th e o th e r ^9 p e r c e n t o f th e re s p o n d in g firm s r e l y e x c l u s i v e l y on ROI o r r e s i d u a l income i n t h e i r a sse ss m e n t o f m a n a g e ria l p e rfo rm a n c e. C o n s id e rin g th e p r e s e n t c o m p o sitio n o f th e s e t o o l m e a su re s, th e firm s who r e l y e x c l u s i v e l y o f t h e i r r e s u l t s a p p e a r to t r e a d in g on d a n g ero u s ground w ith r e s p e c t to f a u l t y a s w e ll a s u n f a i r e v a lu a tiv e r e s u l t s b e in g g e n e r a te d. The firm s u s in g th e above t o o l s were n e x t r e q u e s te d to r a t e each t o o l c l a s s i f i c a t i o n on th e b a s i s o f th e t o o l ' s e v a lu a tiv e e f f e c t i v e n e s s a s w e ll a s each t o o l ' s a b i l i t y to p o s i t i v e l y m o tiv a te segm ent m anagement i n l i t e o f o v e r a l l firm g o a ls. The e v a lu a tiv e r a t i n g s i n b o th r e s p e c t s a re shown i n TABLE 13 (page 7*0 I t i s i n t e r e s t i n g t o n o te t h a t b o th ROI and r e s i d u a l incom e sc o re d more (th o u g h n o t o u ts ta n d in g ) p o i n t s r e g a r d in g t h e i r e v a lu a tiv e e f f e c t i v e n e s s a s opposed t o t h e i r m o tiv a tio n a l p o t e n t i a l. I n f a c t, th e m a jo r ity o f r a t i n g firm s i n d ic a t e d t h a t e i t h e r th e s e t o o l s n eed im provem ent o r th e s e t o o l s were t o t a l l y in a d e q u a te f o r m o tiv a tio n a l o b j e c t i v e s. These f in d in g s i n d ic a t e a n e ed f o r a d d i t i o n a l e x a m in a tio n o f th e r e t u r n on i n v e s t m ent and r e s i d u a l incom e t o o l m easu res i n th e a r e a s o f b o th e v a lu a tiv e e f f e c t i v e n e s s and m o tiv a tio n a l d i r e c t i o n.

88 74- table 13 EVALUATION OF INVESTMENT CENTER PERFORMANCE MEASUREMENT TOOLSi EFFECTIVENESS AND MOTIVATION MEASUREMENT TOOL EVALUATION MEASUREMENT TOOL QUALITIES TOTAL FIRMS 100#* EFFECTIVENESS / MOTIVATION SATISFIED WITH TOOL TOOL COULD BE IMPROVED TOOL I S INADEQUATE The M ea su r e m en t T o o ls a s E f f e c t i v e! ROI *»» # 48# 4# R e s i d u a l I n c o m e # 39# 6# O th e r T o o l s # 48# 2# The M ea su r e m en t T o o ls a s M a n a g e r ia l M o t iv a t o r s * R O I l# 49# 10# R e s i d u a l I n c o m e # 61# 3# O th e r T o o l s # 57# 1# SOURCEi C o rp o ra tio n s re s p o n d in g to q u e s t io n n a ir e. In fo rm a tio n d e riv e d from TABLES 9 and 12.

89 75 SUMMARY The u se o f e i t h e r ROI o r r e s i d u a l income on a r e g u l a r b a s i s i n e v a lu a tin g se g m en tal m a n a g e ria l p e rfo rm an c e i s s t e a d i l y i n c r e a s i n g. Today, m ost com panies w ith two o r more in v e s tm e n t c e n t e r s em ploy e i t h e r o r b o th o f th e s e m e a su re s. Thus, d e c e n tr a li z e d p r o f i t r e s p o n s i b i l i t y h as become d e c e n tr a li z e d in v e s tm e n t - r e tu m r e s p o n s i b i l i t y. W ith t h i s b ro a d e n in g o f m a n a g e ria l r e s p o n s i b i l i t y comes th e n eed to c a r e f u l l y d i s t i n g u i s h betw een th e e v a lu a tio n o f th e in v e s tm e n t c e n te r and th e e v a lu a tio n o f i t s m anagem ent. As m en tio n ed p r e v io u s ly, w h e th er one u s e s ROI o r r e s i d u a l income in e v a lu a tin g segm ent management p e rfo rm a n c e, to p management m ust be m in d fu l o f th e o p e ra tin g c o n s t r a i n t s to w hich th e segm ent m anager i s exposed, f o r h i s a b i l i t y to p ro d u ce p r o f i t s i s l i m i t e d by m arket c o n d itio n s, by th e scope o f a u t h o r i t y d e le g a te d to him, and by th e h i s t o r i c a l background o f th e o p e r a tio n s and f a c i l i t i e s t h a t f a l l w ith in h i s j u r i s d i c t i o n. A c c o rd in g ly, h i s p erfo rm an ce sh o u ld be e v a lu a te d in te rm s o f h i s s u c c e ss i n p ro d u c in g r e s u l t s w ith in th e s e c o n s t r a i n t s. I n th e f i n a l a n a l y s i s, w hat i s need ed i s a com parison o f a c t u a l p erfo rm an ce w ith some s ta n d a rd o f d e s ir e d p e rfo rm a n c e, t a i l o r e d to th e e n v iro n ment in w hich th e in v e s tm e n t c e n te r m anager m ust o p e r a te. F u rth e rm o re, w h e th er th e t o o l u se d i s ROI o r r e s i d u a l incom e i s o n ly one a s p e c t o f th e problem a s s o c i a t e d w ith se g m en tal m a n a g e ria l e v a l u a t i o n. From th e in fo rm a tio n

90 conveyed i n TABLE 13» i t i s o b v io u s t h a t th e r e i s a g r e a t d e a l o f m is u n d e rs ta n d in g r e g a r d in g th e m o tiv a tio n a l and b e h a v io r a l co n seq u en ces o f p erfo rm an ce m e a s u re s In a d d it i o n, and r e l a t e d t o t h i s i s s u e, i s th e problem a s s o c i a t e d w ith m easurem ent t o o l c o m p o sitio n b e c a u se w ith ROI and r e s i d u a l incom e, th e n a tu r e and e x te n t o f t o o l c o n te n t i s f a r from u n ifo rm. Thus, p r o f i t b a se and in v e s tm e n t b a se c r i t e r i a m ust be d e fin e d i n such a way so t h a t t h e i r com bined r e l a t i o n s h i p p ro v id e s b o th an e f f e c t i v e means o f e v a lu a tio n and a p o s i t i v e c a t a l y s t f o r m a n a g e ria l m o tiv a tio n. The re m a in in g c h a p te r s o f t h i s stu d y a re d e v o te d to t h i s e f f o r t w ith in th e g e n e r a l fram ew ork o f ROI and r e s i d u a l income m eth o d o lo g y.

91 C h a p te r ^ ANALYSIS OF INVESTMENT CENTER PROFITi CONTEXT AND COMPOSITION I n o rd e r to e v a lu a te in v e s tm e n t c e n te r m a n a g e ria l p e rfo rm a n c e, i t i s n e c e s s a r y to d e te rm in e a m easure o f b o th th e p e r i o d i c se g m e n ta l p r o f i t and th e a s s e t b a se em ployed i n g e n e r a tin g t h i s p r o f i t. A lthough each o f th e s e com ponents p r e s e n t s a d i s t i n c t m easurem ent p ro b lem, th e y a re i n h e r e n t l y r e l a t e d i n th e fo llo w in g r e s p e c t s i 1. B oth th e in v e s tm e n t b a se and p r o f i t m ust be c o n t r o l l a b l e by th e in v e s tm e n t c e n te r m anager i f he i s to assum e r e s p o n s i b i l i t y and t h e r e f o r e be e v a lu a te d on e i t h e r o f th e s e m ea su re s, and 2. Many e le m e n ts t h a t a f f e c t th e in v e s tm e n t b a se a ls o a f f e c t seg m en tal e x p e n se s e i t h e r th ro u g h a d i r e c t o r in v e rs e r e l a t i o n s h i p, and s u b s e q u e n tly a f f e c t th e f i n a l p r o f i t d e te r m in a tio n a s w e l l. W ith in th e c o n te x t o f th e above i n t e r r e l a t i o n s h i p s, t h i s c h a p te r exam ines th e p r o f i t b a se d e f i n i t i o n and i t s d e r i v a t i o n. C h a p te r 5 p r e s e n t s a c o n te x tu a l and com posit i o n a l a n a l y s i s o f th e se g m e n ta l in v e s tm e n t b a s e. INVESTMENT CENTER PROFIT EVALUATIONi JUSTIFICATION AND PREREQUISITES 77

92 78 The n e e d f o r seg m en tal p r o f i t e v a lu a tio n a r i s e s when m anagement d e s i r e s t o d e te rm in e th e d e g re e o f in v e s tm e n t c e n te r p r o f i t c o n tr i b u ti o n to o v e r a l l c o rp o ra te p r o f i t. To th e e x te n t t h a t segm ent managem ent i s d e le g a te d a d e q u a te d e c is io n a u t h o r i t y to c o n tr o l i t s rev e n u e and e x p e n se s, th e c o n c e p t o f p r o f i t m easurem ent becom es r e l e v a n t and grows in b o th im p o rta n c e and e f f e c t i v e n e s s. As th e o p e r a tio n s o f th e f i r m s segm ents become more d ep en d en t upon th e o p e r a tio n s o f o th e r r e l a t e d seg m en ts, th e segm ent m a n a g e r's freedom o f d e c is io n m aking and th e n eed f o r p r o f i t e v a lu a t i o n d im in is h e s. U nder th e a ssu m p tio n t h a t a d e q u a te d e c i sio n a u t h o r i t y e x i s t s, th e j u s t i f i c a t i o n f o r seg m en tal p r o f i t e v a lu a tio n can be r a t i o n a l i z e d on th e b a s i s o f th e fo llo w in g fo u r o b j e c t i v e s *-^0 1. P r o f i t e v a lu a tio n p r o v id e s an i n d i c a t i o n o f th e p r o f i t a b i l i t y o f th e in v e s tm e n t i n i n d iv i d u a l d i v i s i o n s, m a rk e ts, o r p ro d u c t l i n e s, 2. P r o f i t e v a lu a tio n s e r v e s to i n c r e a s e segm ent m anagem ent's a w are n ess o f th e com pany's p r o f i t o b j e c ti v e s, 3. P r o f i t e v a lu a tio n g u id e s segm ent m anagers to w ard d e c is io n s t h a t w i l l in c r e a s e t o t a l company p r o f i t, and 4. P r o f i t e v a lu a tio n g iv e s to p management some i n d i c a t i o n o f th e e f f e c t i v e n e s s o f segm ent m anagers i n e x e r c i s i n g th e a u t h o r i t y d e le g a te d to them. 3 S h illin g la w, "Problem s i n D iv is io n a l P r o f i t M easurem e n t," op. c i t., p. 3^*

93 79 Q u ite o f te n, how ever, th e d i f f i c u l t i e s t h a t a r i s e i n p r o f i t d e c e n t r a l i z a t i o n stem from th e f a c t t h a t t h i s s i n g u l a r f ig u r e c a l l e d " p r o f i t " i s a sk ed t o do to o many th in g s s im u lta n e o u s ly and w ith o u t a p p r o p r ia te f o u n d a tio n. I n t h i s r e g a r d, S h illin g la w o u t l i n e s th e fo llo w in g th r e e r u l e s w ith w hich p r o f i t m easurem ents m ust comply b e fo re th e y can be r e l e v a n t a s a c c e p ta b le m easu res o f p e rfo rm a n c e i 1. Segment p r o f i t sh o u ld n o t be p e rm itte d to in c r e a s e by any a c t io n t h a t i s d e tr im e n ta l to t o t a l company p r o f i t, 2. Each se g m e n t's p r o f i t sh o u ld be a s in d e p e n d e n t a s p o s s ib le o f p erfo rm an ce e f f i c i e n c y and m a n a g e ria l d e c is io n s o r i g i n a t i n g e lse w h e re i n th e company, and 3. Each s e g m e n t's p r o f i t sh o u ld r e f l e c t a l l ite m s t h a t a re s u b je c t to any s u b s t a n t i a l d eg ree o f c o n tr o l by th e segm ent m anager o r h i s s u b o r d in a te s. To what d e g re e does p r o f i t, d e fin e d i n a cc o rd a n c e w ith g e n e r a l l y a c c e p te d a c c o u n tin g p r i n c i p l e s, p o s s e s s th e c a p a c ity to f u l f i l l th e ab o v e-m en tio n ed p r e r e q u i s i t e s? To h e lp in p ro v id in g an answ er to t h i s in q u ir y, a t t e n t i o n i s d i r e c te d to th e c o n te x t and d e r i v a ti o n o f th e a c c o u n tin g p r o f i t m easu re. ^ Gordon S h illin g la w, C ost A cco u n tin g i A n a ly s is and C o n tro l ( I l l i n o i s i R ic h a rd D. I rw in, I n c., 1961), p } see a ls o h i s a r t i c l e s, "G uides to I n t e r n a l P r o f i t M easurem e n t," H arv ard B u sin e ss R eview, 35 (M a rch -A p ril, 1957)» 8 2-9^ and "Toward a T heory o f D iv is io n a l Income M easurem e n t," The A cco u n tin g R eview, XXXVII ( A p r il, ),

94 80 ANALYSIS OP VARIOUS CONCEPTS OP PROFIT* DETERMINATION AND SIGNIFICANCE In th e d e te rm in a tio n o f e i t h e r r e t u r n on in v e s tm e n t o r r e s i d u a l incom e, th e p r o f i t elem en t i s g e n e r a l l y ta k e n d i r e c t l y from an in v e s tm e n t c e n t e r 's incom e s ta te m e n t w hich i s p r e p a r e d in a cc o rd a n c e w ith g e n e r a lly a c c e p te d a c c o u n tin g p r i n c i p l e s. A c c o rd in g ly, TABLE 14 (page 81) r e v e a l s t h a t 76 p e r c e n t o f th e re s p o n d in g firm s u se o p e r a tin g n e t income e i t h e r b e fo re o r a f t e r th e d e d u c tio n o f incom e ta x e s a s th e p r o f i t b a se in th e ROI c a l c u l a t i o n. I n a d d it i o n, 24 o u t o f 29 firm s which u se b o th ROI and r e s i d u a l income i n a s s e s s ir ^ segm ent management p e rfo rm an c e u t i l i z e th e s e same p r o f i t c o n c e p ts i n b o th m easurem ent c a l c u l a t i o n s. S e v e ra l comm ents r e c e iv e d from re s p o n d in g c o r p o r a tio n s i n d i c a t e t h a t in some i n s ta n c e s "incom e" i s s t i l l re g a rd e d a s some k in d o f s i n g l e - v a lu e, a ll- p u r p o s e t r u t h. However, u n d e r d i f f e r e n t s i t u a t i o n s incom e, a s a c o n c e p t, means d i f f e r e n t th in g s to d i f f e r e n t p e o p le. F or exam ple, Chambers s t a t e s t h a t i t i s p o s s ib le t o m easure a g iv e n f i r m 's ( o r in t h i s c ase firm se g m e n t's) income in a s many a s 30 m il l io n d i f f e r e n t f i g u r e s, a l l o f w hich a re d e te rm in e d i n accordance w ith g e n e r a lly a c c e p te d a c c o u n tin g p r i n c i p l e s. ^ T h e re fo re b e fo re income can be u se d i n c o n ju n c tio n w ith any m easure ^Raymond J. Chambers, "A M a tte r o f P r i n c i p l e s, " The A cco u n tin g R eview. XLI ( J u ly, 1966),

95 81 TABLE 14- ANALYSIS OF ROI PROFIT BASE CONTEXT OF ROI PROFIT ROI PROFIT BASE TOTAL FIRMS PERCENTAGE OF TOTAL TOTAL FIRMS 100# C o n trib u tio n M argin # P erfo rm an ce M arg in \# Segment M argin # 209 N et Income b e fo re Taxes # N et Income a f t e r T axes <# T o ta l Response to I n q u ir y # 209* SOURCEj C o rp o ra tio n s re s p o n d in g to q u e s t io n n a ir e. *O nly firm s u t i l i z i n g ROI were exam ined on t h i s in q u ir y b ecau se th e v a s t m a jo r ity o f firm s u s in g r e s i d u a l income d e fin e incom e f o r t h i s p u rp o se a s n e t incom e b e fo re t a x e s.

96 o f m a n a g e ria l e f f e c t i v e n e s s, i t i s e s s e n t i a l to c l a r i f y i t s c o m p o sitio n. More s p e c i f i c a l l y, i f incom e i s to be a " f a i r " i n d i c a t o r o f m a n a g e ria l p e rfo rm a n c e, t h e v a r io u s f a c t o r s c o n tr i b u ti n g t o i t s s u b s ta n c e m ust be p r o p e r ly i s o l a t e d in to c o n t r o l l a b l e and n o n c o n tr o lla b le e le m e n ts. T h is d i f f i c u l t y r e d u c e s i t s e l f to a d e te r m in a tio n a s t o what sh o u ld be in c lu d e d i n, and w hat sh o u ld be e x c lu d e d from, th e f i n a l p ro d u c t known a s " n e t in co m e." I n t h i s d e r i v a ti o n, how ever, th e r e a re num erous l e v e l s o f " n e t- n e s s r e l a t i v e to incom e. These " n e t- n e s s " r e l a t i o n s h i p s f o r ROI and r e s i d u a l incom e d e te r m in a tio n s a re c o n c e p tu a lly i l l u s t r a t e d in FIGURE 6 (page 8 3 ). - ^ W ith r e f e r e n c e t o t h i s i l l u s t r a t i o n, i t sh o u ld be im m e d ia te ly o b v io u s t h a t th e s ta te m e n t s t r u c t u r e o u t li n e d c an n o t be d e riv e d a c c o rd in g to th e t r a d i t i o n a l l y f u n c t i o n a l ap p ro ach u se d in e x te r n a l f i n a n c i a l r e p o r t i n g ; n o r can t h i s s t r u c t u r e be f u l l y d e v elo p ed th ro u g h e x c lu s iv e a p p l i c a t i o n o f th e b e h a v i o r a l l y - o r i e n te d a p p ro a ch c o v e rte d by d i r e c t c o s tin g. I n s te a d, a c o m b in atio n o f th e above a p p ro a c h e s s e t w ith in 3 3 -'-'For a d d i t i o n a l d is c u s s io n o f p r o f i t l e v e l s, though in some c a se s d e fin e d d i f f e r e n t l y, see C h a rle s T. H o m g ren, C ost A ccounting^ A M a n a g e ria l Em phasis (3d e d. 5 New J e r s e y i P r e n t i c e - H a l l, I n c., 1972), p p. 399-^02; see a ls o th e a r t i c l e s by R u s s e ll B. Read, "V ario u s P r o f i t F ig u re s and T h e ir S i g n i f ic a n c e," N.A.A. B u l l e t i n. 39 (S ep tem b er, 1957), 32-37, W illia m L. S tro n g, " D e c e n tra liz e d O p e ra tio n s 1 A C o n tro l P ro g ram," F in a n c ia l E x e c u tiv e. 26 (J a n u a ry, 1958) 11, and P a t r ic k S. Kemp, " C o n trib u tio n M argin A n a ly s is by Company Segments* T hree U s e s," N.A.A. B u l l e t i n. W (November, 1962), 29-37*

97 RETURN ON INVESTMENT 83 RESIDUAL INCOME N et S a le s $ x,x x x $ x,x x x L e ssi C o n tr o lla b le V a ria b le S egm ental C ost o f Goods S old - x.x x x -x.x x x G ross M arg in $ x,x x x $ x,x x x L e ssi C o n tr o lla b le V a ria b le S egm ental M a rk e tin g and A d m in is tra tiv e E x p e n se s... - x.x x x -x.x x x C o n tr ib u tio n M argin $ x,x x x $ x,x x x L e ssi F ix e d E xpenses D i r e c t l y I d e n t i f i a b l e w ith and C o n tr o lla b le by Segm ent... xxx xxx P erfo rm an ce ( C o n tr o lla b le ) M argin. $ x,x x x $ x,x x x L e ssi I n t e r e s t on C o n tr o lla b le S egm ental In v e s tm e n t B ase ( o r C a p ita l Charge R a te ).. - xxx C o n tr o lla b le R e s id u a l Income M argin. L e s si $ x,x x x O th e r E x p en ses D i r e c t ly I d e n t i f i a b l e w ith b u t n o t C o n tr o lla b le b y Segm ent.. - xxx - xxx Segment M arg in $ x,x x x L e s si I n t e r e s t on N o n c o n tro lla b le P o r tio n o f S egm ental In v e s tm e n t B a se... - xxx S egm ental R e s id u a l Incom e M a rg in... $ x fxxx L e s si A llo c a te d Common o r E x tr a - S egm ental E xpenses N e ith e r D i r e c t ly I d e n t i f i a b l e w ith Nor C o n tr o lla b le by Segm ent. - xxx - xxx N et O p e ra tin g ( o r N et R e s id u a l) Income b e fo re T axes $ x f xxx $ x,x x x L e ssi E s tim a te d Taxes on O p e ra tin g N et Income xxx - xxx N et O p e ra tin g ( o r N et R e s id u a l) Income a f t e r T a x e s... FIGURE 6 CONCEPTUAL ILLUSTRATION OF DEGREES OF "NET-NESS" FOR ROI AND RESIDUAL INCOME DETERMINATION T h is i s th e p r o f i t m easure m ost o f te n u se d i n b o th ROI and R e s id u a l Incom e d e r i v a t i o n.

98 84 an o v e r a l l fram ew ork o f r e s p o n s i b i l i t y a n a l y s i s i s e s s e n t i a l i n o rd e r t o d e v elo p th e l e v e l s o f incom e s p e c i f i e d. The n a tu r e and c o m p o sitio n o f each o f th e p r o f i t l e v e l s n o te d i n FIGURE 6 a re n e x t exam ined. C o n trib u tio n M argin C o n trib u tio n m arg in i s o b ta in e d by d e d u c tin g segm ent v a r i a b le c o n t r o l l a b l e c o s t o f s a l e s, m a rk e tin g, and a d m i n i s t r a t io n from n e t s a l e s. I n d e r iv in g t h i s l e v e l o f p r o f i t, th e p rim a ry fo c u s i s on c o s t c o n tr o l i n th e i n v e s t ment c e n te r r a t h e r th a n on o v e r a l l p e rfo rm an c e e v a l u a t i o n. As such, th e c o n c e p t o f d i r e c t c o s t in g, th o u g h a p p lie d i n d e r iv in g t h i s c a l c u l a t i o n, i s m o d ifie d s l i g h t l y i n o rd e r to f u r t h e r d i s t i n g u i s h betw een c o n t r o l l a b l e and n o n c o n tr o l- l a b l e v a r i a b l e c o s t b e h a v io r p a t t e r n s. T h e re fo re, a t th e in v e s tm e n t c e n t e r e v a lu a tiv e l e v e l, th e p rim a ry i n t e r e s t i n o b ta in in g a m easure o f c o n t r i b u t i o n m arg in i s w ith d e te rm in in g th e v e s te d r e s p o n s i b i l i t y f o r d i r e c t segm ent ex p en se s r a t h e r th a n w ith m e re ly n o t in g a d i s t i n c t i o n betw een th e e x p e n se s d i r e c t and i n d i r e c t n a t u r e. A ccordin g ly, th e o v e r a l l o b j e c ti v e o f d e r iv in g c o n tr i b u ti o n m argin w ith in th e r e s p o n s i b i l i t y scope s p e c i f i e d i s t o r e f l e c t a segm ent m a n a g e r's d i r e c t o p e r a t io n a l c o n tr i b u ti o n to f ix e d and com pany-wide c o n t r o l l a b l e e x p e n s e s. P erform ance M argin P erform ance m arg in d i f f e r s from c o n tr i b u ti o n m argin

99 i n t h a t f ix e d c o s t s, u n d e r th e d i s c r e t i o n a r y d e c is io n in f lu e n c e o f th e in v e s tm e n t c e n te r m anager, a re a ls o deduct e d. F u rth e rm o re, o n ly th o s e f ix e d c o s ts s u b je c t to cont r o l i n th e s h o r t ru n a re d e d u c te d. Thus, a l l com m itted in v e s tm e n t c e n te r f ix e d c o s t s, r e g a r d l e s s o f w h eth er th e com m ittm ent i t s e l f o r i g i n a t e d w ith th e p r e s e n t o r some p re v io u s in v e s tm e n t c e n te r m anager, a re e lim in a te d from c o n s id e r a tio n. C u rre n t d i s c r e t i o n a r y segm ent m a n a g e ria l c o n tr o l i s th e key i n d e r iv in g t h i s m easure o f p r o f i t p e rfo rm a n c e. As su ch, in te r s e g m e n ta l com parison o f c u r r e n t m a n a g e ria l c o n t r i b u ti o n can be i n i t i a t e d on a sound and re a s o n a b le b a s i s i n o r d e r to i s o l a t e weak segm ent m anagers (a s opposed to i s o l a t i n g weak segm ents, w hich i s n o t th e p u rp o se o f t h i s m e a s u re ). I n so d o in g, p erfo rm an ce m arg in i s a s u p e r i o r m easure to c o n tr i b u ti o n m argin b ecau se th e fo rm er m easure in c lu d e s d i s c r e t i o n a r y f ix e d c o s ts in p r o f i t c o n s id e r a tio n, and th e s e may w e ll have an i n t e r a c t i n g e f f e c t on th e v a r i a b l e c o s ts t h a t c o n t r i b u ti o n m argin a n a l y s i s c o n s id e r s e x c l u s i v e l y. A d d itio n a lly, d e r i v a ti o n o f t h i s p erfo rm an ce m argin o r c o n t r o l l a b l e p r o f i t f ig u r e p o s s e s s e s th e f o llo w in g tw o -fo ld a d v a n ta g e a c c o rd in g to R ead. ^ 1. P erfo rm an ce m argin s p e c i f i e s th e p r o f i t o v e r w hich th e segm ent m anager can e x e r c is e im m ediate and d i r e c t c o n tr o l th ro u g h h i s d e c is io n s and a c t i o n s, and ^ R e a d, op, c i t., p. 35.

100 86 2. P erfo rm an ce m arg in e n c o u ra g e s a t e t t e r u n d e rs ta n d in g o f th e se g m e n t's c o s t, s in c e th e d e te r m in a tio n o f t h i s f ig u r e f o r c e s a s e g r e g a tio n betw een c o s ts w hich a re cont r o l l a b l e and th o s e w hich a re n o t i n th e s h o r t ru n. More s p e c i f i c a l l y, i t fo c u s e s on an a n a l y s i s o f f ix e d c o s ts betw een th o s e w hich a re f ix e d by com m ittm ent and th o s e w hich a re f ix e d by o p e r a tin g p o l ic y. W ith r e s p e c t to ite m two above, one o f th e m ost d i f f i c u l t expense ite m s to c l a s s i f y a s c o n t r o l l a b l e v e rs u s u n c o n tr o lla b le i n th e s h o r t ru n a n a l y s i s i s d e p r e c i a ti o n. I f c l a s s i f i e d a s u n c o n tr o lla b le (an d e x c lu d e d from th e p erfo rm an ce m argin f i g u r e ) th e fo llo w in g a d v e rs e s i t u a t i o n c o u ld a r i s e s A segm ent w hich s u b s t i t u t e s c a p i t a l equipm ent f o r l a b o r o v e r a p e r io d o f tim e would show a s te a d y r i s e in c o n t r o l l a b l e p r o f i t a l l o th e r t h in g s b e in g e q u a l b e ca u se th e co m p en satin g r i s e i n d e p r e c ia tio n w ould o n ly be r e f l e c t e d below t h i s c o n t r o l l a b l e p r o f i t l i n e. C o n se q u e n tly, a r e a l d an g er e x i s t s t h a t c o n t r o l l a b l e p r o f i t im provem ent may be shown i n s i t u a t i o n s where no r e a l im provem ent h a s o c c u r re d, sim p ly by s u b s t i t u t i n g s o - c a l l e d u n c o n tr o l la b l e in p u ts f o r c o n t r o l l a b l e in p u ts (eq u ip m en t f o r d i r e c t l a b o r in t h i s c a s e ). The p r o b a b i l i t y o f t h i s s i t u a t i o n a r i s i n g can be s u b s t a n t i a l l y re d u c e d, how ever, i f i t i s r e a l i z e d t h a t, c o rre sp o n d in g to a d i s t i n c t i o n betw een c o n t r o l l a b l e and n o n c o n tr o lla b le e x p en se, i s th e n eed to a l s o c o n s i s t e n t l y d i s t i n g u i s h betw een c o n t r o l l a b l e and n o n c o n tr o lla b le in v e s tm e n t b a se r e s o u r c e s. T h e re fo re, c o n c e p t c o n s is te n c y

101 d i c t a t e s t h a t th e c o s t o f u s in g c o n t r o l l a b l e in v e s tm e n t i s a c o n t r o l l a b l e expense and sh o u ld be d e d u c te d i n d e te rm in 87 in g th e c o n t r o l l a b l e p r o f i t m arg in. F u r th e r d is c u s s io n r e l a t i v e to in v e s tm e n t b a se c o n t r o l l a b i l i t y i s d e f e r r e d to th e n e x t c h a p te r. Segment M argin The segm ent m argin p r o f i t m easure i s d e riv e d a f t e r d e d u c tin g from th e p erfo rm an ce m arg in th o s e d i r e c t l y id e n t i f i a b l e seg m en tal f ix e d c o s t s t h a t a re f ix e d by some p r i o r com m ittm ent and a re th e r e f o r e c o n s id e re d a s u n c o n tr o lla b le by th e segm ent m anager in th e s h o r t ru n. I n e s s e n c e, t h i s p r o f i t m easure i s d e riv e d a f t e r f u l l c o n s id e r a tio n o f a l l d i r e c t l y t r a c e a b le com m itted and d i s c r e t i o n a r y segm ent c o s t s. As su ch, i t i s t h i s p r o f i t m easure f o r w hich th e segm ent i t s e l f ( s e p a r a te and a p a r t from th e segm ent m anager) can be h e ld r e s p o n s ib le, i f th e firm so d e s i r e s to draw an a sse ssm e n t o f t o t a l seg m en tal c o n tr i b u ti o n to company-wide e x p e n se s. The n e c e s s i t y f o r t h i s d i f f e r e n t i a t i o n betw een segm ent and segm ent m anager e v a lu a tio n stem s from th e f a c t t h a t many c o r p o r a tio n s d e l i b e r a t e l y a s s ig n t h e i r b e s t m anagers to t h e i r l e a s t s u c c e s s f u l segm ents in th e hope o f im p ro v in g th e l a t t e r * s p e rfo rm a n c e. I n a d d it i o n, th e p a r a m e te rs o f c o n tr o l te n d to be b ro a d e r on a segm ent a s opp o sed to segm ent m anager l e v e l. Thus, th e need a r i s e s to e s t a b l i s h r e s p o n s i b i l i t y b o u n d a rie s. L a s tly, p erfo rm an ce m easures in v o lv in g seg m en tal management a r e, by n e c e s s i t y,

102 88 s h o r t- te r m i n n a tu r e s in c e segm ent m anager tu r n o v e r and o th e r f a c t o r s w i l l c o n tr ib u te to a te r m in a l e x is te n c e f o r m a n a g e ria l p e r s o n n e l. Segment m ea su re s, on th e o th e r hand, te n d t o be more lo n g -te rm in n a tu r e due t o th e s u r v iv a l v i a b i l i t y o f t h i s s u b e n t it y o v e r and above th e s u r v iv a l o f any s p e c i f i c management team. F o r th e s e r e a s o n s, th e d i s t i n c t i o n betw een a c t i v i t y v e rs u s m anager p r o f i t e v a lu a t i o n s m ust be draw n. R e la tiv e to m a n a g e ria l e v a lu a tio n, th e u se o f segm ent m arg in, th e n, w ould be in a p p r o p r i a t e, sin c e t h i s f i g u r e in v o lv e s lo n g -te rm c o n s id e r a tio n s which may have l i t t l e r e l a t i o n s h i p to th e o p e r a tio n a l e f f e c t i v e n e s s o f p r e s e n t seg m en tal m anagem ent. P r e ta x N et O p e ra tin g Income The p r e t a x p r o f i t m easure i s d e te rm in e d by d e d u c tin g a l l o c a t e d common o r e x tra - s e g m e n ta l ex p en se s from th e segm ent m arg in f i g u r e. O p e ra tin g incom e, i n t h i s r e s p e c t, r e f l e c t s a s e g m e n t's u lti m a t e c o n tr i b u ti o n to o v e r a l l firm p r o f i t a b i l i t y p r i o r to ta x c o n s id e r a tio n s, and i s th e m easure o f p r o f i t ( a s r e v e a le d in TABLE 14) t h a t m ost firm s u se in d e te rm in in g seg m en tal ROI and r e s i d u a l incom e. A c r i t i c i s m o f t h i s p r o f i t m easure i s t h a t i t i s d i f f i c u l t to im agine how se g m en tal m a n a g e ria l p erfo rm an ce can be a s s e s s e d when d e d u c tio n s a re made f o r b o th c e n t r a l and common c o s ts o v e r w hich th e segm ent m anager e x e r c i s e s no in f lu e n c e. The c o u n te r-a rg u m e n t m ost commonly u se d by c o r p o r a tio n s a c c o rd in g to Solomons i s t h a t segm ents m ust

103 be made aw are o f th e f a c t t h a t th e r e a r e n o n se g m en tal c o s ts to be c o v e re d o u t o f segm ent e a r n in g s b e fo r e th e company a s a whole can show a p r o f i t. M oreover, i f th e segm ent was an in d e p e n d e n t company, i t would have a to p m anagement o f i t s own and, t h e r e f o r e, w ould i t s e l f in c u r many o f th e e x p en se s p r e s e n t l y a l l o c a t e d. 35 As c o n v in c in g a s t h i s argum ent may seem, th e f a c t re m a in s t h a t in a r e s p o n s i b i l i t y e v a lu a tio n system, n e t o p e r a tin g income a s a means o f r e l e v a n t se g m e n ta l p e rfo rm an c e a p p r a i s a l i s a r b i t r a r y to th e e x te n t t h a t a l l o c a t e d ex p en ses a r e a r b i t r a r y. A lso, due to i t s se n se o f a l l - i n c l u s i v e n e s s, any a tte m p t to r e f i n e t h i s p r o f i t m easure th ro u g h in v e s tm e n t c e n t e r f r a t i o n a l i z a tio n i s m is le a d in g, b e ca u se th e r e s u l t s o f th e w hole w i l l n e c e s s a r i l y d i f f e r from th e sum o f i t s segm ented p a r t s. T his e f f e c t i s due to th e s y n e r g i s t i c r e a c t i o n on th e c o rp o ra te l e v e l cau se d by th e c o n s o lid a tio n o f c o o rd in a te d subsystem e f f o r t s. N et O p e ra tin g Income A f te r Taxes A f te r t a x p r o f i t s p o s s e s s th e same n a tu r e o f a r b i t r a r i n e s s a s b e fo re ta x p r o f i t s w ith one a d d i t i o n a l dim ens io n. Segm ents, u n le s s o rg a n iz e d a s s e p a r a te c o r p o r a tio n s, do n o t pay incom e ta x e s s in c e t a x e s a re l e v i e d on th e l e g a l e n t i t y o n ly. As su c h, ta x p o l i c y i s i n v a r i a b l y a c o rp o r a te -^S olom ons, op. c i t., p. 73*

104 n o t a segm ent r e s p o n s i b i l i t y and i s t h e r e f o r e n o t c o n t r o l 90 la b l e a t t h i s lo w e r l e v e l. D e sp ite t h i s r e a s o n in g, 3^ p e rc e n t o f th e re s p o n d in g firm s ( a s shown i n TABLE 3A) u se a f t e r ta x p r o f i t s i n t h e i r ROI c a l c u l a t i o n. F o llo w in g Solom ons' se n se o f l o g ic e x p re s s e d on th e p r e v io u s p a g e, th e r a t i o n a l i z a t i o n f o r u t i l i z i n g a f t e r ta x p r o f i t (a s opposed to some o th e r l e s s i n c l u s i v e m easure) in se g m en tal m a n a g e ria l e v a lu a tio n seem s to be t h a t in a d e c e n tr a li z e d o p e ra tio n, t h i s p r o f i t c o n c e p t comes c l o s e s t to a p p ro x i m atin g p erfo rm an ce a s i f th e segm ent had o p e ra te d a s an in d e p e n d e n t e n t i t y. A d d itio n a lly, a lo n g th e l i n e o f th e d e c e n t r a l i z a t i o n p h ilo s o p h y, c o rp o r a te m anagement i s p ro b a b ly a tte m p tin g to e s t a b l i s h i n i t s in v e s tm e n t c e n t e r s a c lim a te p a r a l l e l i n g t h a t o f an autonom ous fir m. I n d o in g t h i s, how ever, to p c o rp o ra te managem ent l o s e s s i g h t o f th e f a c t t h a t an i n t e r n a l segm ent i s n o t d i v i s i b l y s e l f - s u s ta in in g and i t s management does n o t p o s s e s s com plete d e c is io n a u t h o r i t y. Up to t h i s p o i n t, th e d is c u s s io n h a s e lim in a te d b o th b e fo re and a f t e r ta x p r o f i t m ea su re s from s e r i o u s c o n s id e r a ti o n a s v ia b le and m e a n in g fu l m easu res o f e i t h e r seg m en tal o r seg m en tal m a n a g e ria l p e rfo rm an c e e f f e c t i v e n e s s. In a d d it i o n, segm ent m arg in, th ough a v i a b le means o f a s s e s s in g segm ent p e rfo rm a n c e, h a s a ls o b een d is p u te d a s an in a p p r o p r ia te m easure o f se g m en tal m a n a g e ria l e f f e c t i v e n e s s. The p rim a ry re a s o n s f o r e li m in a ti n g a l l th r e e p r o f i t

105 m easu res stem from th e c o n te n tio n t h a t th e s e p r o f i t d e r i v a tio n s a r e, by t h e i r v e ry n a t u r e, " u n f a ir " from th e view p o in t o f th e segm ent m anager who i s s u b je c t t o t h i s e v a lu a t i o n. T h is u n f a i r n e s s p re m ise a r i s e s from th e f a c t t h a t a l l th e above m easu res in c lu d e u n c o n tr o l la b l e and o f te n a l l o c a t e d e le m e n ts i n t h e i r d e te r m in a tio n. A d d itio n a lly, th e s e p r o f i t m easu res a l l em phasize some d e g re e of lo n g term p r o f i t c o n t r i b u t i o n, when, in a c t u a l i t y, b o th ROI and r e s i d u a l incom e sh o u ld seek to d e te rm in e th e s h o r t- te r m p e rfo rm an c e e f f e c t i v e n e s s o f c u r r e n t in v e s tm e n t c e n te r m anagem ent. An e q u a lly im p o rta n t re a s o n f o r e x c lu d in g th e b e fo r e and a f t e r ta x p r o f i t m ea su re s i n i n t e r n a l e v a l u a ti o n s i s t h a t, a s d e te rm in e d i n a cc o rd a n c e w ith g e n e r a lly a c c e p te d a c c o u n tin g p r i n c i p l e s, d e r i v a ti o n o f th e s e p r o f i t m easu res and a m a n a g e ria l a tte m p t to m axim ize th e same c o u ld b re e d a d v e rs e m o tiv a tio n a l te n d e n c ie s i n th e s h o r t ru n. The end r e s u l t s o f t h i s in c o n g ru e n t m o tiv a tio n, c o n s id e r in g th e two extrem e r e a c t i o n s, a re s h o r t - r u n p r o f i t m a n ip u la tio n a s a minimum and lo n g -ru n p r o f i t su b o p tim iz a t i o n a s a maximum c o n se q u e n c e. F a c to r s w hich cau se each o f th e s e a d v e r s i t i e s w i l l now be exam ined. FACTORS CONTRIBUTING TO MANIPULATION AND SUBOPTIMIZATION OF PROFIT The c o n te n tio n in t h i s s tu d y i s t h a t a d v e rs e m o tiv a t i o n a l co n seq u en ces a re due p r i m a r i l y t o f o r c e d m a n a g e ria l em phasis on th e m a x im iz a tio n o f an i n a p p r o p r ia te seg m en tal

106 92 p r o f i t g o a l. A c c o rd in g ly, th e segm ent m anager i s m o tiv a te d to m axim ize th e p r o f i t f a c t o r on w hich he i s to be e v a lu a te d, a s m o tiv a tio n and e v a lu a tio n a re two s i d e s o f th e same c o in. I n an a tte m p t to m axim ize h i s s t a t e d p r o f i t g o a l, th e segm ent m anager l o g i c a l l y p u rs u e s th e m ost d i r e c t ro u te, b u t t h i s d i r e c t r o u te may n o t be th e m ost p r o f i t a b l e one from e i t h e r a lo n g -te rm o r o v e r a l l c o rp o r a te v ie w p o in t. One o f th e g r e a t e s t d a n g e rs, th e n, i n d e c e n t r a l i z i n g p r o f i t r e s p o n s i b i l i t y i s th e m o tiv a tio n t h a t i t g e n e r a te s f o r s h o r t - r u n p r o f i t a cc o m p lish m e n ts. I n t h i s r e s p e c t, D earden l i s t s th e fo llo w in g f o u r s i t u a t i o n s where th e m o tiv a tio n f o r s h o r t- te r m p r o f i t s i s so i n te n s e t h a t p r o f i t m a n ip u la t i o n o r p r o f i t s u b o p tim iz a tio n c o u ld m a t e r i a l i z e i 1. When a firm h a s d e c e n tr a li z e d b e c a u se i t p r e v io u s l y e x p e rie n c e d d i f f i c u l t y i n e a r n in g an a d e q u a te p r o f i t, o r 2. When a segm ent m anager i s r e p la c e d b e ca u se th e segm ent i t s e l f i s n o t e a rn in g a s a t i s f a c t o r y p r o f i t ( i n t h i s c a se th e new m anager f e e l s co m p elled to o b ta in i n s t a n t r e s u l t s ), o r 3. When a segm ent m anager b e li e v e s t h a t he i s "on th e s k id s " ( i n t h i s c a se he h a s e v e ry th in g to g a in and n o th in g to l o s e ), o r 4. When a segm ent h a s been e a rn in g a s a t i s f a c t o r y -^ Jo h n D earden, "L im its on D e c e n tra liz e d P r o f i t R esp o n s i b i l i t y, " H arv ard B u sin e ss R eview, 40 (J u ly -A u g u s t, 1962),

107 93 p r o f i t b u t a new m anager w ish e s to make a name f o r h im s e lf. I n th e a b o v e - o u tlin e d a d v e rs e s i t u a t i o n s, g e n e r a lly a c c e p te d a c c o u n tin g p r i n c i p l e s r e i n f o r c e m a n a g e ria l m o tiv a tio n in t h i s d i r e c t i o n o f s h o r t- te r m p r o f i t a c h ie v e m e n t. In a d d it i o n, u s e o f p ro c e d u re s i n a c c o rd a n c e w ith th e s e p r i n c i p l e s e n a b le s th e segm ent m anager to e i t h e r m a n ip u la te o r su b o p tim iz e p r o f i t s b e ca u se g e n e r a l l y a c c e p te d a c c o u n t in g p r i n c i p l e s p ro v id e th e lo o p h o le s by w hich e i t h e r consequence can m a t e r i a l i z e. S e v e ra l exam ples i l l u s t r a t i n g how a segm ent m anager can m a n ip u la te o r m axim ize p r o f i t s to h i s own a d v a n ta g e ( a s opposed to t h a t o f th e o v e r a l l c o rp o r a ti o n ) a re p r e s e n te d below. However, one m ust keep in mind t h a t i f a segm ent m anager d e c id e s t o ta k e such a c tio n, i t c o u ld a ls o in f lu e n c e th e d e r i v a t i o n o f h i s in v e s tm e n t b a s e. T h is l a t t e r e f f e c t i s d is c u s s e d in th e n e x t c h a p te r. P r o f i t M a n ip u la tio n Exam ples Of th e two a d v e rs e co n seq u en ces d is c u s s e d above, p r o f i t m a n ip u la tio n te n d s to be l e s s s e r io u s th a n p r o f i t s u b o p tim iz a tio n b e c a u s e, i n th e lo n g ru n, th e r e s u l t s o f m a n ip u la tiv e te c h n iq u e s l e v e l o u t and a re r e c o n c i l e d. The f a c t s t i l l re m a in s, how ever, t h a t p erfo rm an ce e f f e c t i v e n e s s w ith in a s h o r t- te r m tim e fram e may be s e r i o u s l y d i s t o r t e d by m a n a g e ria l a c t i o n s r e s u l t i n g from i n t e r n a l a p p l i c a t i o n o f p ro c e d u re s s a n c tio n e d by e x t e r n a l a c c o u n tin g p r i n c i p l e s. The fo llo w in g exam ples d e m o n stra te t h i s p o i n t i L a s t - i n. f i r s t - o u t v a l u a t i o n. T h is form o f in v e n to r y

108 v a lu a tio n e n a b le s a segm ent m anager to v a ry h i s p r o f i t by sim p ly ad d in g o r d e l e t i n g e n d - o f - p e r io d p u rc h a s e s c o n tr a r y to o v e r a l l segm ent n e e d s. A ssum ing a r i s i n g tr e n d i n c o s t p r i c e s, a segm ent m anager can in c r e a s e h i s p r o f i t by d e le t i n g an e s s e n t i a l e n d - o f - p e r io d p u rc h a s e. Of c o u rs e, a r e c i p r o c a l e f f e c t o f t h i s d e l e t i o n c o u ld be s to c k - o u t c o n d itio n s a r i s i n g a t th e b e g in n in g o f th e n e x t p e r io d. On th e o th e r h an d, i f c o s t p r i c e s a r e i n s t e a d f a l l i n g, segm ent p r o f i t can be in c r e a s e d by a d d in g an u n n e c e s s a ry e n d -o f - p e r io d a c q u s i t i o n o f m e rc h a n d ise. Doing so, how ever, would a ls o r e s u l t in t y i n g up c o rp o r a te r e s o u r c e s i n u n e s s e n t i a l a s s e t s. A b so rp tio n ( f u l l ) c o s t i n g. I n a c c o rd a n c e w ith g e n e r a l l y a c c e p te d a c c o u n tin g p r i n c i p l e s, th e b a s i s f o r in v e n t o r y a c c o u n tin g i s c o s t. I n t h i s r e s p e c t, c o s t means " th e sum o f a p p lic a b le e x p e n d itu r e s and c h a rg e s d i r e c t l y o r i n d i r e c t l y in c u r r e d i n b r in g in g an a r t i c l e to i t s e x i s t in g c o n d itio n and l o c a t i o n. "37 R e la tiv e to m a n u fa c tu re d in v e n to ry, a lth o u g h t h i s d e f i n i t i o n does n o t e x c lu d e th e d i r e c t c o s tin g c o n c e p t, i t c e r t a i n l y does n o t en co u rag e i t s u t i l i z a t i o n f o r i n t e r n a l e v a lu a tio n p u rp o s e s. C o n se q u e n tly, f a r to o many firm s c o n tin u e to u se f u l l c o s tin g m ethods i n t e r n a l l y. T h is i s due to b o th th e s t a t e d a l l - i n c l u s i v e ^ D efin e d b y th e A m erican I n s t i t u t e o f C e r tif ie d ^ P u b lic A c c o u n ta n ts Com mittee on A cco u n tin g P ro c e d u re in B u l le t in Number 43, c i t e d by W ilm er L. W rig h t, " D ire c t C o s t i n g - - P r o f i t M easurem ent," N.A.A. B u l l e t i n, 41 (S eptem ber, 1959)» 62.

109 re q u ire m e n ts g o v e rn in g e x t e r n a l f i n a n c i a l r e p o r t i n g and th e la c k o f s u f f i c i e n t i n t e r n a l d i s t i n c t i o n betw een p ro d u c t c o s tin g and p erfo rm an ce e v a lu a tio n d a ta n e e d s. The o v e r a l l problem cau sed by a b s o r p tio n c o s tin g em phasis i s t h a t th e segm ent m anager i s c a p a b le o f i n c r e a s in g p r o f i t s i n th e s h o r t ru n sim p ly by in c r e a s in g h i s p r o d u c tio n n o n p ro p o r- t i o n a t e l y o v e r s a l e s and th e r e b y m a n u fa c tu re f o r in v e n to r y b u ild u p. Thus, p r o f i t s u n d e r a b s o r p tio n c o s tin g te n d to f l u c t u a t e w ith chang es i n p ro d u c tio n a s opposed to changes i n s a l e s. F u rth e rm o re, th e e f f e c t o f a b s o r p tio n c o s tin g on th e b u s in e s s o p e r a tin g c y c le sh o u ld be r e c o g n iz e d. I n t h i s r e s p e c t, when th e b u s in e s s o p e r a tin g c y c le i s h ig h, i n v e n t o r i e s a re a c c u m u la te d and t r u e p r o f i t s a re o v e r s ta te d. C o n v e rse ly, when t h i s c y c le t u r n s down, a cc u m u late d in v e n t o r i e s a re w orked o f f and tim e p r o f i t s a re u n d e r s ta te d th e re b y in c r e a s in g o r a c c e n tu a tin g th e d e p th o f th e c y c le d e p re s s io n. In a d d it i o n to p r o f i t m a n ip u la tio n and b u s in e s s c y c le e f f e c t s, f u r t h e r c r i t i c i s m o f th e f u l l c o s tin g m ethodology stem s from th e f a c t t h a t t h i s ap p ro ach i s n e i t h e r b e h a v io r a l l y o r ie n te d n o r r e s p o n s i b i l i t y o r i e n t e d. T h e re fo re, p r o f i t d e te rm in e d a c c o rd in g to th e c o n v e n tio n a l a l l - i n c l u s i v e a p p ro a ch (fro m w hich th e a b s o r p tio n c o s tin g co n ce p t i s g e n e r a l l y d e riv e d ) draw s no d is tin g u is h m e n t betw een f ix e d and v a r i a b l e, d i v i s i b l e and i n d i v i s i b l e, o r c o n t r o l l a b l e and u n c o n tr o lla b le c o s t d a ta. Only th e u se o f a r e s p o n s i b i l i t y - o r i e n t e d system w ith b e h a v io r a l c o s t

110 96 d i s t i n c t i o n can a l l e v i a t e th e m easurem ent d i f f i c u l t i e s a s s o c i a t e d w ith th e f u l l c o s tin g m eth o d o lo g y. D e p re c ia tio n d e te r m in a tio n. I n a t r u e l y d e c e n tr a li z e d o r g a n iz a tio n, in v e s tm e n t c e n te r m anagers a re g iv e n a l a r g e d e g re e o f freedom to choose t h e i r own i n t e r n a l d e p r e c ia tio n m ethods w h ile th e c h o ic e o f t a x - o r i e n t e d d e p r e c ia tio n t e c h n iq u e s a re l e f t to th e c o rp o r a te l e v e l w ith o u t r e f e r e n c e t o th e in v e s tm e n t c e n te r s e l e c t i o n s. I n f u l l y d e v e lo p e d se g m en ts, th e d e p r e c ia tio n m ethods s e l e c t e d w i l l n o t d i s t o r t r e s u l t i n g p r o f i t s a s s e r i o u s l y a s i n g r o w th - o r ie n te d se g m en ts. The re a s o n f o r n o n d i s t o r t i o n o f p r o f i t s i n th e d e v e lo p e d segm ents i s t h a t th e age o f a s s e t s te n d s to be more e v e n ly d i s t r i b u t e d c o u p le d w ith th e f a c t t h a t th e r e s u l t i n g d e p r e c ia tio n c h a rg e s a re lo w e r r e l a t i v e t o o th e r expense e f f e c t s on p r o f i t d e r i v a t i o n. R e g a rd le s s o f th e d e g re e o f se g m e n ta l d ev elopm ent, how ever, th e i n t e r n a l s e l e c t i o n o f d e p r e c ia tio n m ethods sh o u ld be g u id e d by an a s s e t * s e x p e c te d p e rfo rm a n c e, n o t by such c o n s id e r a tio n s a s ta x m in im iz a tio n and seg m en tal u n if o r m ity. What i s im port a n t, th e n, i s t h a t each s e g m e n t's r e p o r te d p r o f i t r e f l e c t a s a c c u r a t e l y a s p o s s ib l e th e p e rfo rm an c e e f f e c t i v e n e s s o f i t s m anagem ent. As l o g i c a l a s t h i s may seem, TABLE 20 (page 128 in C h a p te r 5) r e v e a l s t h a t 95 p e r c e n t o f th e re s p o n d in g firm s u se th e same m ethod o f d e p r e c i a ti o n i n t e r n a l l y a s th e y do f o r e x te r n a l f i n a n c i a l r e p o r t i n g p u rp o s e s. C o n se q u e n tly, p rim a ry em phasis i n d e p r e c i a ti o n m ethod

111 s e l e c t i o n s t i l l te n d s to be p la c e d on such c o n s id e r a tio n s a s ta x m in im iz a tio n, p r o c e d u r a l c o n s is te n c y, and seg m en tal u n if o r m ity. As su ch, th e o p p o r tu n ity f o r s h o r t- te r m p r o f i t m a n ip u la tio n and d i s t o r t i o n can assum e a num ber o f d im e n sio n s. F or exam ple, a p p l i c a t i o n o f th e c o s t c o n ce p t i n i t s t r a d i t i o n a l form d i s t o r t s and f a l s i f i e s p l a n t a s s e t d e riv e d p r o f i t s b e c a u se in p u t d e p r e c ia tio n c h a rg e s a re v a lu e d i n d o l l a r s o f h ig h e r p u rc h a s in g pow er th a n a re th e o u tp u t rev en u e f a c t o r s. F u rth e rm o re, th e u se o f e x t e r n a l d e p r e c i a ti o n m ethods f o r i n t e r n a l e v a lu a tio n s te n d s t o o v e r s t a t e " r e a l" p r o f i t a s th e r e l a t e d p l a n t a s s e t s age b e ca u se th e s e e x te r n a l d e p r e c i a ti o n m ethods f a i l to p r o p e r l y r e f l e c t th e l o s s i n p l a n t a s s e t o p e r a tin g u t i l i z a t i o n o v e r tim e. I n a d d it i o n, Dearden^ c i t e s s e v e r a l s i t u a t i o n s in w hich th e a ssig n m e n t o f p l a n t a s s e t s to segm ents a t t h e i r g r o s s c o s t w h ile a c c o u n tin g f o r d e p r e c i a ti o n u s in g a co m p o site r a t e, e n c o u ra g e s segm ent m anagers to p re m a tu re ly e lim in a te te m p o ra ry i d l e f a c i l i t i e s. I n D e a rd e n 's exam ples, a segm ent, in d is p o s in g o f th e s e f a c i l i t i e s, e s c a p e s th e r e l a t e d d e p r e c i a ti o n c h arg e a s w e ll a s any l o s s on t h i s p re m a tu re d i s p o s a l. The fo re g o in g d e p r e c ia tio n exam ples n o t o n ly d is p u te th e n e c e s s i t y f o r i n t e r n a l and e x te r n a l m ethod c o n s is te n c y and u n if o r m ity, b u t a ls o p o in t o u t th e sh o rtc o m in g s o f u s in g th e h i s t o r i c a l c o s t c o n c e p t i n p l a n t 3 John D earden, "P roblem s i n D e c e n tra liz e d P r o f i t R e s p o n s i b i l i t y," H arv ard B u sin e ss R eview. 38 (M ay-june, I9 6 0 ),

112 98 a s s e t v a lu a ti o n. The p r o f i t d i s t o r t i o n exam ples i l l u s t r a t e d i n th e above s e c t i o n s a re n o t th e o n ly i n s t a n c e s t h a t can be c i t e d j th e y sim p ly te n d t o be r e p r e s e n t a t i v e o f th e o v e r a l l r e s u l t s t h a t can m a t e r i a l i z e when t h e r e e x i s t s a c o m b in atio n o f im p ro p er m o tiv a tio n and in a p p r o p r i a t e m easurem ent p r o c e d u re s. I n th e s h o r t ru n, th e e f f e c t o f m a n ip u la tiv e p r a c t i c e s can d i s t o r t th e p e rfo rm a n c e a p p r a i s a l p r o c e s s to such an e x te n t t h a t th e p r o f i t f i g u r e s d e riv e d can be q u i te d i f f e r e n t f o r two segm ent m anagers e x h i b i t i n g id e n t i c a l a c t u a l p e rfo rm a n c e. P r o f i t S u b o p tim iz a tio n Exam ples The p rim a ry f o r e r u n n e r t o a s u b o p tim iz a tio n s i t u a t i o n a p p e a rs to be th e e x is te n c e o f e i t h e r in te r s e g m e n ta l comp e t i t i o n o r in te r s e g m e n ta l d e p en d en ce. S u b o p tim iz a tio n in e i t h e r c ase i s d e fin e d a s th e n e g a tiv e s y n e r g i s t i c e f f e c t t h a t i s g e n e r a te d i n th e o v e r a l l c o r p o r a tio n when a segm ent o p tim iz e s i t s s h o r t- te r m p erfo rm an ce to th e s h o r t- o r - lo n g - te r m d e tr im e n t o f th e c o rp o r a te w h o le. I t sh o u ld be re c o g n iz e d a t t h i s p o i n t t h a t an in c r e a s e in one s e g m e n t's p r o f i t o v e r and above a r e l a t e d d e c re a s e in a n o th e r s e g m e n t's p r o f i t does n o t n e c e s s a r i l y c o n s t i t u t e s u b o p tim iz a tio n a s th e term i s u se d i n t h i s s tu d y, b e ca u se a t l e a s t i n th e s h o r t ru n, th e s y n e r g i s t i c e f f e c t s on th e c o rp o ra te whole a re p o s i t i v e. The fo llo w in g exam ples d e m o n stra te th e way in w hich s u b o p tim a l s i t u a t i o n s a r i s e i

113 99 T r a n s f e r p r i c i n g s i t u a t i o n. B oth se g m e n ta l c o m p e tit i o n and in te rd e p e n d e n c e can be r e f l e c t e d i n th e i n t e r n a l t r a n s f e r o f goods and s e r v i c e s. The p r i c e a t w hich th e s e t r a n s f e r s i s acknow ledged s im u lta n e o u s ly i n f lu e n c e s b o th th e t r a n s f e r e e s in v e n to r y b a se and th e t r a n s f e r o r 's p r o f i t t o t a l. In a d d it i o n, th e s m a lle r and more num erous th e segm ents in v o lv e d, th e more im p o rta n t t h i s r e c i p r o c a l in f lu e n c e becom es, and th e more d e p en d e n t i s th e e n t i r e p r o f i t m easure on th e d e s ig n a te d t r a n s f e r p r i c e. T h eref o r e, th e m o tiv a tin g a s p e c t o f t r a n s f e r p r i c e s i s o f p rim a ry im p o rta n c e b e ca u se w ith im p ro p e r o r u n f a i r i n t e r n a l p r i c e s, m o tiv a tio n a l te n d e n c ie s a r i s e t h a t may le a d to a c t i o n s c o n tr a r y to o v e r a l l c o rp o r a te i n t e r e s t s. F or exam ple, an in v e s tm e n t c e n te r m anager d o es n o t have any i n c e n t i v e to g iv e b u s in e s s to a n o th e r i n t e r n a l segm ent i f he can p u rc h a se from e x te r n a l v e n d o rs a t a lo w e r p r i c e. In t h i s c a s e, w h ile th e p a r t i c u l a r b u y in g s e g m e n t's p r o f i t may b e n e f i t due to th e lo w e r e x p e rie n c e d p u rc h a s in g c o s t s, th e c o rp o ra t i o n a s a whole s e r v e s t o lo s e th e p r o f i t m arg in on i n t e r segm ent s a l e s w hich w ould o th e rw is e be m ade. To i l l u s t r a t e t h i s p o in t from a s l i g h t l y d i f f e r e n t a n g le, c o n s id e r th e fo llo w in g r e p r e s e n t a t i v e s i t u a t i o n i A segm ent was p u rc h a s in g an i d e n t i c a l p a r t from b o th an o u ts id e so u rc e and a company seg m en t. The r u l e s p ro v id e d t h a t, in c a s e s o f t h i s ty p e, th e i n t e r n a l p r i c e w ould be e x a c tl y th e same a s th e e x te r n a l p r i c e. The b u y in g segm ent w ould be a b le to n e g o ti a t e p r i c e s w ith th e o u ts id e s o u rc e more e f f e c t i v e l y i f i t had in f o rm a tio n r e l a t i v e to th e m a n u fa c tu rin g c o s t s o f th e ite m in q u e s tio n. But

114 th e i n t e r n a l s e l l i n g segm ent was r e l u c t a n t to g iv e any in fo rm a tio n r e l a t i v e to th e p r o d u c t 's c o s t f o r f e a r t h a t th e o u ts id e p r i c e w ould be re d u c e d, c a u s in g th e i n t e r n a l t r a n s f e r p r i c e t o a ls o be l o w e r e d. 39 I n th e above c a s e, s u b o p tim iz a tio n r e s u l t s b ecau se 100 w ith o u t th e p e r t i n e n t c o s t in fo rm a tio n a v a i l a b l e i n t e r n a l l y, th e buy in g segm ent w i l l have to pay a h ig h e r p r i c e th a n i t c o u ld o th e rw is e n e g o ti a t e i f i t had p r o p e r a c c e s s t o t h i s c o s t d a ta. T h e re fo re, even though th e i n t e r n a l s e l l i n g segm ent o p tim iz e s i t s p r o f i t p o s i t i o n, th e c o r p o r a tio n a s a whole s u f f e r s to th e e x te n t o f th e h ig h e r e x t e r n a l p u r chase p r i c e in c u r r e d by th e b u y in g segm ent. C ost a l l o c a t i o n. The p o s i t i o n ta k e n i n t h i s s tu d y i s t h a t i n d i v i s i b l e and n o n tr a c e a b le c o s t s sh o u ld n o t be a l l o c a te d in e v a lu a tin g in v e s tm e n t c e n t e r m a n a g e ria l p erfo rm an ce! how ever, to th e e x te n t t h a t th e s e a l l o c a t i o n s a r e p r e s e n t l y made by c o r p o r a tio n s, a d is c u s s io n o f t h e i r p o t e n t i a l sub- o p tim iz in g e f f e c t i s e s s e n t i a l. As shown i n TABLE 15 (page 101), o n ly 29 p e r c e n t o f th e firm s u t i l i z i n g in v e s tm e n t c e n te r m a n a g e ria l r e s p o n s i b i l i t y do n o t a l l o c a t e common c o s t s, w h ile th e o th e r 71 p e r c e n t u se s i n g u l a r o r m u ltip le m ethods o f c o s t a l l o c a t i o n. T his h ig h p e rc e n ta g e i s n o t to o s u r p r i s i n g in view o f th e f a c t t h a t th e v a s t m a jo r ity o f firm s p r e v io u s ly s t a t e d t h e i r u t i l i z a t i o n o f b e fo re o r a f t e r ta x income a s th e p r o f i t b a se i n t h e i r m easure o f 39john D earden, " I n t e r d i v i s i o n a l P r i c i n g, " H arvard B u sin e ss R eview. 38 ( J a n u a ry -F e b ru a ry, 1 9 ^ 0 ), ll5 " I

115 101 TABLE 15 ANALYSIS OF SEGMENTAL COMMON COST ALLOCATION METHODS NATURE OF COMMON COST ALLOCATION METHODS ALLOCATION BASE TOTAL FIRMS PERCENTAGE OF TOTAL TOTAL FIRMS 100* Common c o s t s a re n o t a l l o c a t e d S a l e s G ross P r o f i t * A s s e ts E m ployed * 215 I n v e s te d C a p ita l !% Number o f E m p lo y ees * O th er M ethods# # * Total. R esponse to I n q u ir y # 127^ 215 SOURCEi C o rp o ra tio n s re s p o n d in g to q u e s t io n n a ir e, R esponse p e rc e n ta g e e x ce ed s 100* b e c a u se 35 o u t o f 215 firm s gave m u ltip le an sw ers t o t h i s i n q u ir y. O ther m ethods m en tio n ed in c lu d e th e fo llo w in g w ith th e d eg ree o f fre q u e n c y i n p a r e n th e s e s i M a s s a c h u s e tts fo rm u la (4), f i n is h e d goods p ro d u c tio n volume (4), s e r v ic e p ro v id e d b a s i s (5)» c o s t o f s a l e s (2), segm ent v e rs u s firm w e ig h tin g b a s i s in v o lv in g a s s e t s and s a l e s (3)» v a r io u s c o m b in a tio n s o f th e above d ep en d in g on th e n a tu r e o f th e c o s t to be a l l o c a t e d (10).

116 102 ROI and r e s i d u a l incom e. I n a d d it i o n, th e fu n d am e n ta l id e a t h a t i n d i v i d u a l s sh o u ld be c h arg ed o n ly w ith th e c o s ts u n d e r t h e i r e x c lu s iv e c o n tr o l, though c o n c e p tu a lly a p p e a l in g, i s d i f f i c u l t to a p p ly p r a c t i c a l l y b e c a u se t h e r e a re few e le m e n ts o f c o s t t h a t a re th e s o le r e s p o n s i b i l i t y o f any one p e rs o n, w ith e v id e n c e o f t h i s c o n te n tio n p r e v io u s ly p r e s e n te d in TABLE 4. As su c h, f o r p u rp o s e s o f a l l o c a t i o n a n a l y s i s, m a n a g e ria l e x p e n d itu re c o n tr o l assum es one o r more o f th e fo llo w in g th r e e fram ew orks 1. A segm ent m anager i s f r e e t o shop aro u n d and h a s th e a u t h o r i t y to a c c e p t o r r e j e c t c e n t r a l l y p ro d u c e d in h o u se s e r v i c e s i n fa v o r o f o b ta in in g th e s e s e r v i c e s e x t e r n a l l y. I n s i t u a t i o n s o f t h i s ty p e, i f th e in h o u se s e r v ic e s a re s e l e c t e d, th e r e s u l t i n g c o s t i s c o n s id e re d a s f u l l y c o n t r o l l a b l e by th e segm ent m anager. 2. A segm ent m anager i s n o t f r e e t o s e l e c t betw een i n t e r n a l and e x t e r n a l s e r v ic e s o u rc e s, b u t he i s f r e e to d e te rm in e th e e x te n t to w hich he u t i l i z e s th e in h o u se s e r v i c e s i n q u e s t io n. In t h i s c a s e, o n ly th e q u a n ti t y f a c t o r o f th e t o t a l s e r v ic e c o s t i s c o n t r o l l a b l e by th e segm ent m anager, w h ile th e p r i c e f a c t o r i s c o n t r o l l a b l e e lse w h e re i n th e o r g a n iz a tio n (i.e., c e n t r a l i z i n g p u rc h a s in g ). ^ S olom ons, op. c it., p p. 7 ^-75 and H o m g ren, "Choosin g A l t e r n a ti v e A cco u n tin g P r a c t i c e s f o r R e p o rtin g to M anagem ent," op. c it., pp

117 A segm ent m anager i s n o t f r e e to d e c id e e i t h e r th e s e r v ic e o r i g in o r th e q u a n t i t y o f th e s e r v ic e he m ust u t i l i z e. I f h o th d e c is io n s a re d e te rm in e d e lse w h e re i n th e o r g a n iz a tio n, th e n th e r e s u l t i n g s e r v ic e expense i s a ls o f u l l y c o n t r o l l a b l e e ls e w h e re i n th e o r g a n iz a tio n. G e n e ra lly, i t i s w ith in t h i s t h i r d d e c is io n fram ework t h a t many o f th e a l l o c a t i o n problem s o r i g i n a t e. D i f f i c u l ties in t h i s r e s p e c t seem to e x i s t b e ca u se o f two in h e r e n t c o s t c h a r a c t e r i s t i c s! A la c k o f c o s t- to - s e g m e n t t r a c e a - b i l i t y and th e e x is te n c e o f s u b s t a n t i a l i n d i v i s i b i l i t i e s i n th e c o s t ite m i t s e l f. A ll o th e r th in g s b e in g e q u a l, th e m ag n itu d e o f c o s t a l l o c a t i o n i s d i r e c t l y p r o p o r t io n a l to th e d e g re e o f se g m e n ta tio n e x i s t i n g w ith in a company; t h e r e f o r e, th e m ag nitude o f th e r e l a t e d a l l o c a t i o n p roblem s v a r i e s a c c o r d in g ly. As su ch, su b o p tim a l s i t u a t i o n s m ost o f te n a r i s e b e ca u se o f th e u t i l i z a t i o n o f f a u l t y o r u n f a i r a l l o c a t i o n te c h n iq u e s. These te c h n iq u e s may o ffe n d o r d is c o u ra g e segm ent m anagers t o th e p o in t o f su b o p tim iz in g o v e r a l l c o rp o ra te p r o f i t s i n o r d e r to a s s u r e t h e i r own segm ent p e rfo rm an c e s e l f - p r e s e r v a t i o n. To i l l u s t r a t e, assum e t h a t c e n t r a l a d m i n i s t r a t iv e e x p e n se s a re to be a l l o c a t e d to th e v a r io u s in v e s tm e n t c e n t e r s, and th e a l l o c a t i o n b a s i s i s in v e s tm e n t c e n te r s a l e s. H ere, an a d v e rs e s i t u a t i o n may o c c u r i f an i n v e s t m ent c e n t e r m anager a tte m p ts to r e s t r i c t h i s s e g m e n t's s a l e s i n o r d e r t o a t t r a c t a c o rre s p o n d in g ly re d u c e d expense

118 104 a l l o c a t i o n. A segm ent m anager w ould "be l i k e l y to i n i t i a t e p r e c i s e l y t h i s ty p e o f a c t i o n i f he s u s p e c te d t h a t h i s added a l l o c a t i o n ex p en se s h a re w ould he in e x c e s s o f th e c o n t r i b u ti o n m arg in t h a t c o u ld be g e n e ra te d on th e s a l e s in q u e s tio n. A c a se i n p o i n t would e v o lv e a s f o llo w s i Assume t h a t $ 20,000 o f a d d i t i o n a l segm ent s a l e s w ould in c r e a s e t h i s s e g m e n t's c o n t r i b u t i o n m arg in by $2,0 0 0 b u t w ould a ls o a t t r a c t an i n c r e a s e o f $2,3 0 0 i n c e n t r a l e x p e n se s by means o f s a le s - b a s e d a l l o c a t i o n. R e la tiv e to t h i s i l l u s t r a t i o n, i f th e segm ent m anager consum ates th e a d d i t i o n a l s a l e s, h i s s e g m e n t's n e t incom e w ould d e c re a s e by $300. C o n v e rsely, i f he f a i l s to i n i t i a t e th e s e s a l e s, th e c o rp o r a te p r o f i t s a s a whole w ould d e c lin e by $2,0 0 0 in l o s t se g m en tal cont r i b u t i o n. The above s i t u a t i o n n o t o n ly i l l u s t r a t e s su b o p tim a l m o tiv a tio n, b u t a ls o shows how one s e g m e n t's c o s t a l l o c a t i o n may r i s e sim p ly b e c a u se, a l l o th e r th in g s b e in g e q u a l, a n o th e r s e g m e n t's s a l e s have d e c lin e d. I n e s s e n c e, a segm ent m a n a g e r's c o s t may i n c r e a s e and h i s p r o f i t s a c c o rd in g ly d e c re a s e by e v e n ts e n t i r e l y o u ts id e h i s rea lm o f c o n tr o l when a s a l e s b a s i s i s u s e d f o r c o s t a l l o c a t i o n. In t h i s r e s p e c t, TABLE 15 shows t h a t 32 p e r c e n t o f th e firm s re s p o n d in g to t h i s i n q u i r y u t i l i z e th e s a l e s b a s i s in t h e i r a l l o c a t i o n o f common c o s t s. S l i g h t m o d if ic a tio n o f th e above exam ple w i l l a ls o i l l u s t r a t e t h a t i t i s p o s s ib l e to a l l o c a t e c o s t s on a b a s i s t h a t r e f l e c t s no a p p a re n t r a t i o n a l r e l a t i o n s h i p w ith r e s p e c t

119 105 to seg m en tal o p e r a tio n s. To d e m o n s tra te t h i s p o i n t, assume t h a t i n s t e a d o f s a l e s, th e a l l o c a t i o n o f c e n t r a l a d m in ist r a t i v e ex p en se s i s by means o f se g m en tal g r o s s p r o f i t. In t h i s c a s e, th e n, th e more p r o f i t a b l e a segm ent i s, th e h ig h e r w ould be i t s p r o p o r t io n a l s h a re o f th e s e c e n t r a l c o s t s ; y e t, t h i s consequence makes l i t t l e se n se b e ca u se i t i s more r a t i o n a l to assum e t h a t th e l e s s p r o f i t a b l e segm ents a re th e ones t h a t r e q u i r e th e g r e a t e s t a t t e n t i o n from c e n t r a l m anagem ent. P o s s ib ly th e exam ples c i t e d above h e lp to e x p la in th e re a s o n why in v e s tm e n t c e n t e r m anagers o f te n c o n s tru e th e c o s t a l l o c a t i o n p r o c e s s n e g a t i v e l y a s " c r e a t i v e a c c o u n tin g " d e sig n e d to i n h i b i t se g m en tal g o a l a tta in m e n t. Opening up th e p o s s i b i l i t y f o r such a r e a c t i o n, how ever, makes no se n se a t a l l b e c a u se i f n o n se g m en tal and common c o s ts a r e, i n f a c t, c o m p le te ly in d e p e n d e n t o f th e segm ent m a n a g e r's d e c is io n d i s c r e t i o n, a l l o c a t i o n w ould seem to be u n n e c e ssa ry a s o v e r a l l c o rp o r a te p r o f i t s w ould n o t be in f lu e n c e d anyway. F u rth e rm o re, Kemp n o te s two a d d i t i o n a l o b j e c ti o n s t o th e u se o f a l l o c a t i o n s in p r o f i t d e r i v a ti o n d e sig n e d to a s s e s s m a n a g e ria l p e rfo rm an ce 1. The f a c t t h a t a l l o c a t i o n i s to some d e g re e i n a c c u ra te f r e q u e n t ly le a d s to c o n te n tio n s t h a t i t i s u n f a i r, and \ \ A ^Kernp, op. c i t., p. 2 9.

120 I t i s i l l o g i c a l t o assum e t h a t i t i s p o s s ib l e f o r company segm ents to e a rn a p r o f i t o r s u s t a i n a l o s s ( s in c e th e y a r e n o t in d e p e n d e n t o p e r a tin g u n i t s to b e g in w ith, b u t a re in s t e a d m e re ly p a r t o f a g r e a t e r w h o le. T h e re fo re, w h ile th e a l l o c a t i o n p r o c e s s may have i t s r i g h t f u l p la c e i n p ro d u c t c o s t d e te r m in a tio n, t h i s same p r o c e s s can r e s u l t i n m is le a d in g and o f te n m e a n in g le ss in f o rm a tio n when a p p lie d i n d e r iv in g p e rfo rm a n c e e v a lu a tio n s. By i t s v e ry n a t u r e, th e n, c o s t a l l o c a t i o n i s n e v e r a c c u r a te, and a t b e s t, i t can o n ly be s a id to be r e a s o n a b le. To sum m arize, th e o v e r a l l co n seq u en ce o f p r o f i t subo p tim iz a tio n te n d s to be more s e r i o u s th a n p r o f i t m a n ip u la t i o n. W ith p r o f i t m a n ip u la tio n, th e e f f e c t i s s h o r t term and n o rm a lly f u l l y r e c o n c i l i a b l e in th e lo n g ru n when tim in g la g s in th e m atch in g p r o c e s s a re e lim in a te d ; how ever, w ith p r o f i t s u b o p tim iz a tio n, th e e f f e c t th e more l i k e l y t o be lo n g term i n n a t u r e, and fu rth e rm o re, i s n o t r e s o lv a b le u n t i l th e s i t u a t i o n i s p e rc e iv e d and s p e c i f i c a c t io n i s i n i t i a t e d. INFLUENCE OF VARIOUS LEVELS OF PROFIT ON ROI» THE SENSITIVITY ANALYSIS W ith in t h i s c h a p te r, f i v e s p e c i f i c l e v e l s o f p r o f i t " n e t- n e s s " w ere i d e n t i f i e d and d i s t i n g u i s h e d. The p r o f i t l e v e l s e l e c te d i n th e m easure o f ROI can s i g n i f i c a n t l y e f f e c t th e o u tp u t r a t i o r e s u l t s, a s shown i n TABLE 16 (page ). T h is t a b l e m arks th e b e g in n in g o f th e ROI

121 T A B L E 1 6 ESTABLISHMENT OF ORIGINAL ROI SENSITIVITY PARAMETERS FOR CORPORATION USED IN SENSITIVITY STUDY i r:vestment BASE COHTRIBUTTON MARGIN PROFIT BASE PERFORMANCE MARGIN SEGMENT MARGIN INCOME BEFORE TAXES INDUSTRIAL FRODUCT-GROUP INVESTMENT CENTERS INCOME AFTER TAXES Plant Assets 9 BV Plant Acsets 9 Cost ?! Fl.int Assets 9 BV ^ * «* * a ?! Plant Assets 9 Cost + '.VC ,73 To!::il Assets 9 BV A A. 7?! To Pal t" INDUSTRIAL PLASTICS PRODUCT-LINE SEGMENT Plant a ssets 9 BV Plant Cost FIant Assets 9 BV + ViC ** Plant Assets 9 Cost + '.VC "otal Assets 9 BV Total Assets 9 COSt. *.. a INDUSTRIAL CHEMICALS PRODUCT-LINE SEGMENT Plant Assets 9 3V Plant Assets 9 Cost Plant Ascot:: 9 DV.i C.. «.. « Plar.t Assets. 9 Cost +.VC Total Assets 9 BV Total A ssets 9 Cost. a. a INDUSTRIAL SYNTHETICS PRODUCT-LINE SEGMENT Plant Assets 9 BV Plant Assets 9 Cost* a» « PI tnt. Assets 9 BV - '.VC Plant Assets 9 Cost + VJC a.. r , Total A ssets 9 BV Cotal Assets 9 C o tta *, a SOURCEi Corporation p articip atin g in s e n s itiv ity study.

122 s e n s i t i v i t y a n a l y s i s m en tio n ed i n C h a p te r 1, and c o n ta in s th e o r i g i n a l r e t u r n on in v e s tm e n t p a ra m e te r v a lu e s t h a t 108 w i l l be s u b s e q u e n tly t e s t e d f o r s e n s i t i v i t y. D ata f o r t h i s t a b l e was o b ta in e d from TABLES 2 and 3 (p a g e s 18 and 19) w hich o u t li n e th e t e s t f i r m 's b a la n c e s h e e t and incom e s ta te m e n t r e s p e c t f u l l y. R e la tiv e to TABLE 16, th e p rim a ry o b s e rv a tio n a t t h i s p o in t i n th e a n a l y s i s i s th e v o l a t i l e re s p o n se o f th e ROI r a t i o r e l a t i v e to in p u t c o m p o s itio n. C o n s tru c tio n o f th e v a r io u s m a tr ic e s th ro u g h o u t t h i s s tu d y w i l l e n a b le t h i s ROI r a t e v a r i a b i l i t y t o be a s s e s s e d in two ways > 1. By s e l e c t i n g a s p e c i f i c in v e s tm e n t b a se l e v e l and re a d in g each m a tr ix h o r i z o n t a l l y, th e e f f e c t o f d i f f e r e n t l e v e l s o f p r o f i t on ROI can be a s c e r t a i n e d, and 2. By s e l e c t i n g a s p e c i f i c l e v e l o f p r o f i t and r e a d in g each m a trix v e r t i c a l l y, th e e f f e c t on ROI o f v a rio u s in v e s tm e n t b a se c o m p o s itio n s can be i n t e r p r e t e d. A lso w orth n o t in g i n TABLE 16 i s th e f a c t t h a t m ost o f th e r e t u r n r a t e s in b o th th e p l a s t i c s and s y n t h e t i c s s e c t o r s exceed th o s e i n i t i a l r a t e s e s t a b l i s h e d f o r th e i n d u s t r i a l p ro d u c t group a s a w h o le, As w i l l be demons t r a t e d i n th e n e x t c h a p te r, a s i t u a t i o n o f t h i s ty p e c o u ld c r e a te th e fram ew ork f o r su b o p tim a l p r o d u c t - l i n e d e c is io n m aking. L a s tly, a lth o u g h t h i s s e n s i t i v i t y a n a l y s i s w orks e x c lu s iv e ly w ith th e r e t u r n on in v e s tm e n t t o o l, th e th e d i r e c t i o n o f s e n s i t i v i t y would n o t s i g n i f i c a n t l y d i f f e r

123 109 i f th e t o o l t e s t e d w ere i n s t e a d r e s i d u a l incom e. B efore p ro c e e d in g f u r t h e r w ith t h i s s e n s i t i v i t y a n a l y s i s, an e x a m in a tio n o f in v e s tm e n t t a s e c o n te x t and c o m p o sitio n i s e s s e n t i a l. T h is e x a m in a tio n w i l l be p u rsu e d i n C h a p te r 5«SUMMARY An in v e s tm e n t c e n te r m anager i n h i s d e c is io n p ro c e s s c an n o t be e x p e c te d t o ig n o re th e e f f e c t o f h i s a c tio n s on h i s s e g m e n t's o v e r a l l p r o f i t a b i l i t y. As d e m o n stra te d in t h i s c h a p te r, p r o f i t c a l c u l a t e d i n th e t r a d i t i o n a l m anner in a c c o rd a n c e w ith g e n e r a lly a c c e p te d a c c o u n tin g p r i n c i p l e s may b re e d s i t u a t i o n s i n w hich th e r e s u l t i n g d e c is io n p r o c e s s i s l e s s th a n o p tim a l to th e c o r p o r a tio n a s a w hole. In a s e n s e, " I f one o p tim iz e s th e p e rfo rm an c e o f th e l i v e r, one w i l l k i l l th e b o d y." C o rp o ra tio n s may be c o u r tin g t h i s same f a t e th ro u g h i t s encouragem ent o f se g m en tal p r o f i t p e rfo rm a n c e. Thus* d e c is io n s may be made t h a t im prove se g m e n ta l " re p o rte d " p r o f i t b u t a t th e tim e tim e a d v e rs e ly a f f e c t th e f i r m 's " r e a l" p r o f i t p e rfo rm a n c e. To t h i s e x te n t, th e n, p r o f i t d e riv e d in a cc o rd a n c e w ith g e n e r a lly a c c e p te d a c c o u n tin g p r i n c i p l e s may be more th e r e s u l t o f th e a c c o u n tin g p ro c e d u re s a p p lie d th a n w ith th e in v e s tm e n t c e n te r m a n a g e r's p erfo rm an ce t h a t i t i s suppose to r e v e a l. I n view o f t h i s o b s e r v a tio n, n e t o p e ra tin g p r o f i t, i n c l u s iv e o f u n c o n tr o l la b l e s h o r t ru n and a l l o c a t e d c o s t s, i s an i n a p p r o p r ia te m easure o f m a n a g e ria l p r o f i t e f f e c t i v e n e s s.

124 C h a p te r 5 ANALYSIS OF INVESTMENT CENTER RESOURCE B A SEi CONTEXT AND COM POSITION The p e rc e n ta g e o f p r o f i t t o n e t s a l e s, o r f o r t h a t m a tte r any o th e r m easure o f p r o f i t p e rfo rm a n c e, does n o t c o n s t i t u t e a com plete a sse ss m e n t o f m a n a g e ria l e f f e c t i v e n e s s b e c a u se p r o f i t m ea su re s f a i l to c o n s id e r th e r e s o u r c e s em ployed i n g e n e r a tin g re v e n u e s on w hich p r o f i t m arg in s have been e a rn e d. Thus, i n th e d e r i v a ti o n o f e i t h e r ROI o r r e s id u a lin c o m e, a m easure o f th e seg m en tal in v e s tm e n t b ase m ust a ls o be d e te rm in e d. I n o r d e r to c o rre sp o n d w ith th e d e r i v a ti o n o f p r o f i t d is c u s s e d i n C h a p te r *+, th e in v e s tm e n t b a se m easure sh o u ld a ls o be re m o te ly r e l a t e d to th e seg m en tal b a la n c e s h e e t p re p a re d i n a c c o rd a n c e w ith g e n e r a l l y a c c e p te d a c c o u n tin g p r i n c i p l e s. W hile to p management may be somewhat c o g n iz a n t o f th e p r o f i t m easure p ro b le m s, i t s m ethods o f r e s o u rc e b ase d e te r m in a tio n seem to i n d i c a t e t h a t c o rp o ra te m anagement does n o t re c o g n iz e th e more s e r io u s l i m i t a t i o n s i n h e r e n t in th e t r a d i t i o n a l l y d e riv e d in v e s tm e n t b a s e. As such, to p management may f a i l to re c o g n iz e th e l i m i t a t i o n s a s s o c i a t e d w ith th e a p p l i c a t i o n o f th e in v e s tm e n t c e n te r r e s p o n s i b i l i t y c o n c e p t. E v id en ce to s u p p o rt t h i s c o n te n tio n 110

125 Ill w i l l be p r e s e n te d in th e fo llo w in g in v e s tm e n t b a se d is c u s s io n. INVESTMENT B A SEt CONTEXTUAL D E F IN IT IO N S I f a com pany's o b je c tiv e i s t o m easure th e p erfo rm an ce e f f e c t i v e n e s s o f seg m en tal m anagem ent, in v e s tm e n t i s d e fin e d a s th e a s s e t s p la c e d a t th e m a n a g e r's d i s p o s a l. I n term s o f p r a c t i c a l a p p l i c a t i o n, th e com panies su rv e y e d e x p re s s e d d i f f e r i n g p o i n ts o f view a s t o how t h i s b a se sh o u ld be defined.in g e n e r a l, th e c o n c e p ts u s e d by th e s e firm s seem to c o in c id e w ith th e f o llo w in g d e f i n i t i o n a l v a r i a t i o n s c i t e d by th e N a tio n a l A s s o c ia tio n o f A c c o u n t a n t s,^ 1. In v e s tm e n t b a se i s d e fin e d a s " t o t a l a s s e t s a v a i l a b l e," I f one u s e s t h i s d e f i n i t i o n, th e b a se c o n s i s t s o f th e t o t a l a s s e t s e n tr u s te d t o m anagement c u sto d y, r e g a r d l e s s o f where such a s s e t s o r i g i n a t e. T h is d e f i n i t i o n a ls o f a i l s to c o n s id e r th e f a c t t h a t some o f th e s e a s s e t s may n o t, a t th e p r e s e n t tim e, be c a p a b le o f p ro d u c in g any ty p e o f r e t u r n. 2. In v e s tm e n t b a se i s d e fin e d a s " t o t a l a s s e t s emp lo y e d." I f t h i s co n cep t i s a d o p te d, e x c e s s o r i d l e a s s e t s a re e lim in a te d from th e in v e s tm e n t b a s e. ^ 2 T h is o b s e rv a tio n i s b a se d on a g e n e r a l e x a m in a tio n o f co m p leted q u e s tio n n a ir e s s u b m itte d by re s p o n d in g f ir m s. ^ N a t i o n a l A s s o c ia tio n o f A c c o u n ta n ts, R e tu rn on C a p ita l a s a Guide to M a n a g e ria l D e c is io n s. R e s e a r c h R e p o r t Number 35 (New YorkV N a tio n a l A s s o c ia tio n o f A c c o u n ta n ts, 1959), P. 35.

126 In v e s tm e n t b a se i s d e fin e d a s " t o ta l a s s e t s employed i n o p e r a t io n s," T h is more r e s t r i c t i v e d e f i n i t i o n e x c lu d e s from th e b a se a l l n o n o p e ra tin g a s s e t s and c u r r e n t a s s e t s h e ld to pay s h o r t- te r m c r e d i t o r s. The o v e r a l l p ro b lem w ith th e p re c e d in g d e f i n i t i o n a l i n t e r p r e t a t i o n s i s t h e i r f a i l u r e to a d e q u a te ly d i s t i n g u i s h betw een segm ent m anager " c o n tr o l" and "c u sto d y " a s th e s e r e l a t e to th e s e g m e n t's a s s e t r e s o u r c e s. I n view o f t h i s w eakness, a f o u r th d e f i n i t i o n o f th e in v e s tm e n t b a se i s o f f e r e d f o r c o n s id e r a tio n i n t h i s stu d y i In v e s tm e n t b a se i s d e fin e d a s " c o n t r o l l a b l e a s s e t s em ployed w ith in a se g m en t." I t sh o u ld be n o te d t h a t th e above d e f i n i t i o n in c lu d e s p a r t o f i n t e r p r e t a t i o n s two and t h r e e and a ls o em p h asizes th e r o l e o f c o n tr o l a s opposed to m ere c u sto d y o f r e s o u r c e s. INVESTMENT BASE DERIVATION PROBLEMS In d e te rm in in g th e e le m e n ts w hich sh o u ld be in c lu d e d in o r e x c lu d e d from a segm ent m a n a g e r's in v e s tm e n t b a s e, th e em phasis i n t h i s stu d y i s p la c e d on " s u b s t a n t i a l " m a n a g e ria l c o n tr o l o v e r th e r e s o u r c e s in q u e s tio n, b e c a u se a s i n d ic a t e d e a r l i e r, few a s s e t s a r e e x c l u s i v e l y c o n t r o l l a b l e a t t h i s l e v e l in th e o r g a n i z a t i o n. F u rth e rm o re, no a tte m p t i s made to d e fin e th e d e g re e o f c o n tr o l im p lie d by th e term s u b s t a n t i a l, a s t h i s sh o u ld be d e te rm in e d i n i n d iv i d u a l firm s by m u tu al ag reem en t betw een se g m en tal and

127 113 to p m anagem ent. I n a d d it i o n to t h i s p ro b lem o f r e s o u rc e in c lu s io n or e x c lu s io n, th e v a lu a ti o n o f r e s o u r c e s in c lu d e d in th e d e f i n i t i o n o f th e in v e s tm e n t b a se m ust be d e te rm in e d. CURRENT ASSET COMPONENT OF THE INVESTMENT BASE As shown in TAiBLE 17 (page ), th e v a s t m a j o r it y o f re s p o n d in g firm s b e lie v e t h a t c u r r e n t a s s e t s a r e c o n t r o l l a b l e by th e segm ent m anager and sh o u ld, t h e r e f o r e, be in c lu d e d in h i s re s o u rc e b a s e. The a s s e t s n o rm a lly i n c l u ded in th e c u r r e n t b a se a r e c a sh, e x te r n a l r e c e i v a b l e s, and in v e n to r y. V a lu a tio n o f In c lu d e d C u rre n t A s s e ts A lthough th e v a lu a tio n o f c u r r e n t a s s e t s in c lu d e d in th e in v e s tm e n t b a se te n d s t o v a ry among co m panies, th e fo llo w in g s e c tio n s exam ine th e m ethods w hich i n d u s t r y p r a c t i c e and an e x a m in a tio n o f r e l a t e d l i t e r a t u r e i n d i c a t e a re th e m ost o f te n u t i l i z e d. ^ C ash. I n m ost c a s e s a segm ent m anager does n o t have th e a u t h o r i t y to manage c a sh b a la n c e s b e ca u se c e n t r a l i z e d c o n tr o l o f te n p r o v id e s f o r more e f f i c i e n t u t i l i z a t i o n o f t h i s r e s o u r c e. At th e same tim e, how ever, many firm s w ish to h o ld th e segm ent m anager r e s p o n s ib le f o r th e "n o rm a l ^ J o h n Dear den, "P roblem s i n D e c e n tr a liz e d F in a n c ia l C o n tr o l," H arvard B u sin e ss R eview, 39 (M ay-june, 1961), 73-77; see 5 c T t., p p *17 and T erborgh,

128 TABLE 17 ANALYSIS OP SEGMENTAL INVESTMENT BASEi CURRENT A SSET SEC TIO N QUESTIONNAIRE INQUIRY AND ASSET BASE RESPONSE A re t h e f o l l o w i n g c u r r e n t a s s e t s i n c l u d e d i n a s e g m e n t 's r e s o u r c e b a s e? TOTAL FIRMS CURRENT ASSET SECTION OF INVESTMENT BASE YES NO NOT APPLICABLE PERCENTAGE OF TOTAL TOTAL FIRMS PERCENTAGE OF TOTAL TOTAL FIRMS PERCENTAGE OF TOTAL Cash * 4 2* I n t r a f i r m R e c e i v a b l e s * 82 38* 13 6* T ra d e R e c e i v a b l e s * 2 1* Raw M a t e r i a l I n v e n t o r y * 2 1* 2 1* W o r k - in - P r o c e s s I n v e n t o r y * 2 1* 2 F i n i s h e d G oods I n v e n t o r y * 2 1* 2 i* O th e r C u r r e n t A s s e t s * 4 l 19* 2 i* A re L. I. P. O. b a s e d i n v e n t o r i e s a d j u s t e d, b e f o r e b a s e i n c l u s i o n t o r e f l e c t a p p r o x im a te r e p la c e m e n t v a l u e? * 51 24* * TOTAL FIRMS 100* 215 SOURCE* C o r p o r a t io n s r e s p o n d in g t o q u e s t i o n n a i r e.

129 amount o f c ash t h a t he w ould r e q u i r e i f he was o p e r a tin g an 115 in d e p e n d e n t b u s in e s s. I n t h i s s i t u a t i o n, cash i s o f te n a l l o c a t e d t o th e seg m en tal in v e s tm e n t b a se by means o f a p re d e te rm in e d fo rm u la. I n t h i s r e s p e c t, th e m ost p o p u la r a l l o c a t i o n b a s i s te n d s to be d o l l a r s a l e s o r s a l e s volum e. T hree o b je c tio n s to th e u se o f s a l e s a s a b a s i s o f a l l o c a t i o n a r e i 1. When s a l e s a re low, a minimum amount o f c a sh i s in c lu d e d, th e re b y m i t i g a t i n g th e o v e r a l l e f f e c t o f re d u c e d p r o f i t s in p e rfo rm a n c e a s s e s s m e n t, 2. C o sts, n o t s a l e s, makes th e m ain ten a n ce o f a cash b a la n c e e s s e n t i a l. The s a l e s b a s i s i s t h e r e f o r e a r b i t r a r y and n o t r e p r e s e n t a t i v e o f se g m e n ta l c ash n e e d s, and 3. I n grow th seg m en ts, i f s a l e s i s u s e d t o a l l o c a t e c a s h, seg m en tal in v e s tm e n t w i l l be o v e r s t a t e d due t o th e la c k o f e q u a l i t y betw een s a l e s and th e u se o f w orking c a p i t a l r e s o u r c e s. F u rth e rm o re, th e w hole id e a o f in c lu d in g c ash in th e c o n t r o l l a b l e in v e s tm e n t d e r i v a ti o n i s q u e s tio n a b le, b e c a u se no m ethod o f a l l o c a t i o n, how ever " f a i r " i t may b e, can r e n d e r a n o n c o n tr o lla b le r e s o u rc e a s c o n t r o l l a b l e. T rade r e c e i v a b l e s. W hether e x te r n a l r e c e i v a b le s a re a c o n t r o l l a b l e com ponent o f m a n a g e ria l r e s o u r c e s on th e segm ent l e v e l depends on w h e th er c r e d i t and a c c o u n t c o l l e c t i o n c o n tr o l i s c e n t r a l i z e d o r d e c e n t r a l i z e d. Assuming th e l a t t e r, th e v a lu a ti o n o f th e s e in c lu d e d r e c e i v a b le s

130 p r e s e n t s a l e s s fo rm id a b le ta s k th a n th e tr e a tm e n t o f cash b ecau se se g m en tal r e c e i v a b le d i v i s i b i l i t y i s f a r e a s i e r to 116 a s c e r t a i n. As su ch, e x t e r n a l r e c e i v a b le s a re n o rm a lly in c lu d e d in th e b a se a t t h e i r a c t u a l e n d - o f - p e r io d a cc o u n t b a la n c e s. A c r i t i c i s m o f th e u s e o f t h i s m ethod o f v a lu a t i o n i s t h a t i t can le a d to b o th s h o r t- te r m d i s t o r t i o n in se g m en tal p r o f i t p e rfo rm a n c e and p o s s ib le su b o p tim a l d e c i s io n a c t i o n s w ith lo n g -te rm c o n se q u e n c e s. For ex am p let A segm ent m anager i n s i s t e d t h a t an a l l - o u t e f f o r t be made to c o l l e c t a s much a s p o s s ib l e o f h i s a c c o u n ts r e c e i v a b le (many o f them o n ly a day o r two d e lin q u e n t) a t th e end o f th e p e r io d i n q u e s tio n. T h is n o t o n ly cau se d u n n e c e s s a ry a d d i t i o n a l c o l l e c t i o n e x p e n se s to be i n c u r r e d i n th e s h o r t ru n, b u t, more im p o r ta n tly, c r e a te d much i l l w i l l on th e p a r t o f t h i s segm ent m a n a g e r's c u s to m e rs.^5 I n v e n t o r i e s. S in c e th e segm ent m anager g e n e r a l l y h as a u t h o r i t y o v e r t h i s a s s e t c a te g o ry, in v e n to r y q u a n t i t i e s a re u s u a l l y in c lu d e d in th e in v e s tm e n t b a se by d i r e c t i d e n t i f i c a t i o n. The o n ly c o n tr o l e x c e p tio n r e l a t e s to th e c e n t r a l i z e d p u r c h a s in g o f raw m a t e r i a l s, how ever, u n le s s p r i c e f l u c t u a t i o n s a r e s e v e r e, v e ry l i t t l e problem i s p r e s e n te d by t h i s s i t u a t i o n s in c e q u a n ti t y i s g e n e r a l l y more s i g n i f i c a n t th a n p r i c e. I n a d d it i o n, th e segm ent m anager can i n d i r e c t l y in f lu e n c e th e p r i c e to be p a id by e i t h e r c h a n g in g r e - o r d e r l e v e l s o r a d ju s ti n g p ro d u c tio n s c h e d u le s. I n b o th c a s e s, th e tim in g o f th e r e l a t e d raw ^ D e a r d e n, "P roblem s i n D e c e n tra liz e d F in a n c ia l C o n tr o l," op. c i t., p.?6.

131 117 m a t e r i a l p u rc h a s e i s e f f e c t e d, and i f p r i c e f l u c t u a t i o n s a re th e r u l e, th e tim e o f e n tr y i n t o th e m ark et assum es im p o rta n c e. F u rth e rm o re, by p o s s e s s in g th e above d e c is io n d i s c r e t i o n, segm ent m anagement can c o n tr o l th e l e v e l o f p ro d u c t in v e n to r y. As su ch, th e p rim a ry t h r e a t to c o rp o r a t e o p tim iz a tio n i s th e p o s s i b i l i t y o f in v e n to r y s to c k o u ts m a t e r i a l i z i n g, b e c a u se when in v e n to r y q u a n t i t i e s in c r e a s e, a l l o th e r th in g s b e in g e q u a l, b o th ROI and r e s i d u a l income te n d to d e c r e a s e. I n v a lu in g th e s e in v e n to r y q u a n t i t i e s, a c c o u n tin g book v a lu e s a re n o rm a lly u s e d. Thus, a d d i t i o n a l p roblem s r e l a t i v e t o t h i s form o f v a l u a ti o n can em erge. The s p e c i f i c p ro b lem c au se d by L.I.F.O. v a lu a tio n i n th e in v e s tm e n t b a se i s exam ined in th e n e x t s e c t i o n. C u rre n t A s se t V a lu a tio n A d ju stm en ts V a lu a tio n a d ju s tm e n ts may be n e c e s s a r y to c o r r e c t i n e q u i t i e s t h a t can o th e rw is e r e s u l t from th e u se o f e x t e r n a l r e p o r t i n g v a lu a ti o n s f o r i n t e r n a l m easurem ent p u rp o s e s. The fo re m o st exam ple o f th e n e ed f o r a d j u s t i n g c u r r e n t a s s e t s i s th e s i t u a t i o n w here a firm u s e s l a s t - i n, f i r s t - o u t in v e n to r y v a l u a t i o n. TABLE 17 shows t h a t 39 p e r c e n t o f th e re s p o n d in g firm s u se L.I.F.O. v a lu a ti o n on e x te r n a l s ta te m e n ts and o f t h i s 39 p e r c e n t, 60 p e r c e n t do n o t r e a d j u s t in v e n to r y v a lu e s when d e r iv in g th e in v e s tm e n t b a s e. I n a d d it i o n to th e d a n g er o f p r o f i t m a n ip u la tio n c i t e d in C h a p te r two f u r t h e r p ro b lem s emerge when L.I.F.O.

132 118 v a l u a t i o n i s a l l o w e d t o e n t e r t h e i n v e s t m e n t b a s e i 1. The i n v e n t o r y v a l u a t i o n t h a t r e s u l t s w i l l r a r e l y b e r e p r e s e n t a t i v e o f e i t h e r a c t u a l i n v e n t o r y c o s t o r i n v e n t o r y p r e s e n t v a l u e, a n d 2. O ld e r s e g m e n t s a r e n o t e n c o u r a g e d t o c u t i n v e n t o r y q u a n t i t i e s t o t h e m o s t e f f i c i e n t l e v e l p o s s i b l e i n p e r i o d s o f i n f l a t i o n f o r f e a r t h a t t h e y w i l l h a v e t o r e l i n q u i s h lo w i n v e n t o r y v a l u e s. The ROI r a t i o c a n a l s o b e s i g n i f i c a n t l y a f f e c t e d b y t h e c h o i c e o f v a l u a t i o n m e t h o d s. To i l l u s t r a t e t h i s p o i n t, t h e f o l l o w i n g s i t u a t i o n w a s a d a p t e d t o t h e c o r p o r a t i o n p a r t i c i p a t i n g i n t h e s e n s i t i v i t y a n a l y s i s i n o r d e r t o t e s t t h e r e l a t i v e s e n s i t i v i t y o f t h e ROI p a r a m e t e r v a l u e s p r e v i o u s l y show n i n TABLE 16 ( p a g e 107)* An a ssu m e d c o n v e r s i o n fr o m F.I.F.O. to L.I.F.O. v a l u a t i o n o c c u r r e d a t t h e e n d o f ^ A s a r e s u l t, t h e i n d u s t r i a l p r o d u c t g r o u p a n d i t s t h r e e r e l a t e d p r o d u c t - l i n e s e g m e n t s e x p e r i e n c e d t h e f o l l o w i n g d e c r e a s e i n t h e i r i n v e n t o r y b a s e a n d p r o f i t a s o f t h e c l o s e o f 197^* P l a s t i c s = $ 1 0 0,0 0 0 C h e m ic a ls = 8 2 8,0 0 0 S y n t h e t i c s = T o t a l P r o d u c t-g r o u p = From t h e a b o v e, i t i s o b v io u s t h a t t h e c h e m ic a ls s e g m e n t i s t h e o l d e s t o f t h e t h r e e. T he s y n t h e t i c s s e c t o r, th o u g h t h e y o u n g e s t s e g m e n t, h a s a l a r g e q u a n t i t y o f i n v e n t o r y on h a n d i n c o m p a r is o n w i t h t h e p l a s t i c s s e c t o r, a s sh ow n i n TABLE 2 (p a g e 18). The r e s u l t s o f t h i s s e n s i t i v i t y t e s t a r e sh ow n i n TABLE 18 (p a g e 119). As i n d i c a t e d i n t h i s t a b u l a t i o n, t h e ROI r a t i o i s m o st s e n s i t i v e t o t h e o l d e s t s e g m e n t a n d l e a s t

133 TABLE 18 SENSITIVITY OF ROI ASSUMING INVENTORY VALUATION CHANGED FROM FIFO TO LIFO DURING 1974 INVESTMENT BASE CONTRI3UTI0N MARGIN PROFIT BASE PERFORMANCE MARGIN SEGMENT MARGIN INDUSTRIAL PRODUCT-GROUP INVESTMENT CENTERS INCOME BEFORE TAXES INCOME AFTER TAXES Plant Assets 0 BV * Plant A ssets 9 Cost PLant A ssets 9 BV VJC Plant A ssets 9 Cost + WC ft - 8, Total A ssets 9 BV ? , Total A ssets 9 Cost ? INDUSTRIAL PLAS't'tos PRODUCT-LINE SEGMENT Plant A ssets 9 BV Plant A ssets 9 Cost t lant A ssets 0 BV v/c ila n t Assets 0 Cost + VJC ,5 local Assets 0 3V Total A sset- 0 -OS t.» «« , ' INDUSTRIAL CHEMICALS PRODUCT-LINE SEGMENT Plant Assets 0 BV , Plant Assets 0 Cost Plant Assets 0 BV VJC... * * , Plant Assets Cost + WC Total Assets 0 BV S'? Total Assets 0 Cost... *» INDUSTRIAL SYNTHETICS PRODUCT-LINE SEGMENT Plant Assets 0 BV -1 o Plant Assets 0 Co st.,,,,, OiS io.o Plant Assets 0 BV t 1 C Plant Assets 0 Cost + WC Total Assets 0 BV Total Assets 0 Cost. «.., Vs. it\ O 1 SOURCEi Corporation p articip atin g in s e n s itiv ity study.

134 120 s e n s i t i v e to th e y o u n g e s t. The l a t t e r e f f e c t h o ld s t r u e d e s p ite th e f a c t t h a t th e d o l l a r v a lu a tio n change f o r p l a s t i c s and s y n t h e t i c s i s th e sam e. The re a s o n f o r t h i s d i f f e r e n t i a t i o n i n r a t e s e n s i t i v i t y i s t h a t th e th e l a r g e r q u a n ti t y o f in v e n to r y i n th e s y n t h e t i c s ( a s opposed t o p l a s t i c s ) s e c t o r i s b e t t e r a b le to a b so rb th e im p act o f th e o v e r a l l v a lu a ti o n r a t e ch an g e. F i n a ll y, a lth o u g h ROI i s d e c re a s e d and th u s u n d e r s ta te d in th e y e a r o f F.I.F.O. to L.I.F.O. change, in su b se q u e n t y e a rs ROI w i l l be in c r e a s e d and t h e r e f o r e o v e r s ta te d b e ca u se th e change in in v e n to r y v a lu e te n d s t o be more perm anent th a n th e change in se g m e n ta l p r o f i t. C u rre n t A sse t A d d itio n s I n c e r t a i n i n s t a n c e s i t may be n e c e s s a r y t o add " e x t e r n a l l y m is s in g " a s s e t s to th e c u r r e n t a s s e t segm ent b a se i n o rd e r f o r t h i s b a se to be r e a l i s t i c a l l y r e p r e s e n t a t i v e o f a l l c o n t r o l l a b l e r e s o u r c e s. The m ost n o ta b le o f th e s e e x t e r n a l l y n o n re c o g n iz e d r e s o u r c e s a re th o s e t h a t emerge from in te r s e g m e n ta l t r a n s a c t i o n s. The in f lu e n c e o f i n t e r n a l ex ch an g es on th e in v e s tm e n t b a se i s r e f l e c t e d i n b o th th e b u y in g s e g m e n t's in v e n to r y and th e s e l l i n g se g m e n t's c ash o r a c c o u n ts r e c e i v a b l e. T h is n eed f o r a d d in g th e e f f e c t o f i n t e r n a l t r a n s f e r s to th e s e g m e n t's i n v e s t m ent b a se a r i s e s whem 1. The t r a n s f e r p r i c e u se d i n th e exchange i s d e t e r m ined by th e segm ents in v o lv e d i n s t e a d o f b e in g d i c t a t e d

135 121 by c e n t r a l m anagem ent, and 2. B oth th e b u y in g and s e l l i n g segm ents a re c o m p le te ly f r e e to d e a l w ith e i t h e r i n t e r n a l o r e x te r n a l m a rk e ts. I n o th e rw o rd s, a lth o u g h an i n t e r n a l p r i c i n g system i s r e q u ir e d w henever a firm h a v in g i n t e r n a l t r a n s a c t i o n s decent r a l i z e s p r o f i t r e s p o n s i b i l i t y, th e r e s u l t o f a 't r a n s f e r i s n o t n e c e s s a r i l y in c lu d e d i n e i t h e r th e s e g m e n t's in v e s tm e n t b a se o r p r o f i t d e r i v a ti o n u n le s s th e above two p r e r e q u i s i t e c o n d itio n s a re a ls o s a t i s f i e d. The e x te n t to w hich i n t e r n a l p r i c i n g sy stem s a re em ployed i n th e firm s su rv e y e d i s shown i n TABLE 19 (page ). T h is t a b l e shows t h a t 92 p e rc e n t o f th e fir m s w hich d e c e n t r a l i z e in v e s tm e n t c e n te r r e s p o n s i b i l i t y u t i l i z e some form o f t r a n s f e r p r i c i n g s y s tem. I n d e te rm in in g th e a p p r o p r ia te n e s s o f v a r io u s p r i c i n g system s i n seg m en tal m a n a g e ria l e v a lu a tio n, a p rim e cons i d e r a t i o n in v o lv e s " f a i r n e s s " o f th e t r a n s f e r p r i c e to b o th th e t r a n s f e r o r and t r a n s f e r e e. I n a d d it i o n, th e p r i c i n g system u t i l i z e d m ust s u p p o rt th e o v e r a l l c o n tr o l system by m a in ta in in g c o n s is te n c y i n m a n a g e ria l d e c is io n a c tio n s betw een in v e s tm e n t c e n te r and c o rp o r a te i n t e r e s t s. W ith r e s p e c t to th e l a t t e r p o i n t, Solomons d e f in e s th e t h e o r e t i c a l l y c o r r e c t t r a n s f e r p r i c e a s th e p r i c e t h a t «f e n a b le s " th e a c t i v i t i e s o f two segm ents ( t r a n s f e r o r and t r a n s f e r e e ) ta k e n t o g e t h e r to be th e same a s i f th e y had been j o i n t l y o rg a n iz e d a s a s in g le in v e s tm e n t c e n t e r. " ^ ^ Solom ons, op. c i t., p

136 122 TABLE 19 ANALYSIS OF SEGMENTAL INVENTORY TRANSFER PRICES NATURE OF TRANSFER PRICE TRANSFER BASIS TOTAL FIRMS TOTAL PERCENTAGE 1 FIRMS OF TOTAL 100# T r a n s f e r p r i c i n g n o t a p p li c a b l e. 17 8# N e g o tia te d p r i c e s # M a rg in al c o s t # S ta n d a rd m a rg in a l c o s t # S ta n d a rd c o s t p l u s f ix e d p e r c e n t m a r k u p... 4 i 19# A c tu a l c o s t p lu s f ix e d p e rc e n t markup # M arket s e l l i n g p r i c e ^# P r ic e s e t by c e n t r a l m anagem ent. 4 2# O th e r m ethods# # # 215 T o ta l R esponse t o I n q u i r y *!!! # 1I 215 SOURCE* C o rp o ra tio n s re s p o n d in g to q u e s tio n n a ir e, R esponse p e rc e n ta g e e x ce ed s 100# b e ca u se 20 out o f 215 firm s gave m u ltip le an sw ers t o t h i s i n q u ir y. O ther m ethods m en tio n ed in c lu d e th e fo llo w in g w ith th e d e g re e o f fre q u e n c y i n p a re n th e s e s * A c tu a l c o s t w ith no markup ( 5 )* s ta n d a rd c o s t p lu s v a r i a b le markup ( 7 )* s ta n d a r d c o s t ( 5 )» m ark et s e l l i n g p r i c e l e s s n e g o tia te d d is c o u n t f o r e x p e n se s a v o id e d by s e l l i n g i n t e r n a l l y ( 9 )*

137 In v ie w in g TABLE 19» to what e x te n t does th e p r i c i n g m ethods shown s a t i s f y b o th th e two p r e r e q u i s i t e s c i t e d 123 e a r l i e r and Solomons t h e o r e t i c a l p re m ise? I t w ould a p p e a r t h a t a l l th e c o s t- b a s e d sy stem s f a i l in b o th r e s p e c t s b e ca u se o f t h e i r fo llo w in g c h a r a c t e r i s t i c s! 1. A ll c o s t- b a s e d t r a n s f e r p r i c e s a re to some degree a u t h o r i t a r i a n i n n a tu r e, and 2. P ro d u c t c o s tin g, e s p e c i a l l y i f th e r e s u l t s a re a ls o a p p lie d i n e x te r n a l r e p o r t i n g, i s n o t c o n cern ed w ith th e " m o tiv a tio n a l" a s p e c ts o f p r i c i n g w hich a re so im port a n t to i n t e r n a l d e c is io n o p tim iz a tio n. I n m ost c a s e s, c o s t- b a s e d sy stem s p ro v id e n e g a tiv e i n c e n ti v e, o r a t b e s t no i n c e n ti v e, f o r c o s t r e d u c tio n on th e p a r t o f th e su p p ly in g in v e s tm e n t c e n te r (i.e., f u l l c o s t p r i c i n g and m a rg in a l c o s t p r i c i n g ). R e la tiv e to th e above, TABLE 19 shows t h a t a p p ro x i m a te ly 35 p e r c e n t o f th e re s p o n d in g firm s a p p ly some form o f c o s t - o r i e n t e d t r a n s f e r p r i c e in t h e i r i n t e r n a l t r a n s a c t i o n s. At th e same tim e, i t i s e n c o u ra g in g to n o te t h a t a n o th e r 60 p e r c e n t o f th e re s p o n d in g firm s u se th e fo llo w in g m ethods o f i n t e r n a l p r i c i n g, a l l o f w hich te n d to be more co n d u civ e t o f u l f i l l i n g b o th th e p r e r e q u i s i t e c o n d i t i o n s c i t e d on page 120 and Solom ons' t h e o r e t i c a l p re m ise. M arket b a se d t r a n s f e r p r i c i n g. T h is form o f p r i c i n g i s u se d by 2b p e rc e n t o f th e re sp o n d in g firm s and c o n s i d e rs th e e x te r n a l m ark et i n a r r i v i n g a t a t r a n s f e r p r i c e

138 124 f o r i n t e r n a l p u rp o s e s. I n u s in g m ark et p r i c e s, th e o b v io u s p rim a ry p r e r e q u i s i t e i s t h a t an e x te r n a l m ark et e x i s t, o th e rw is e th e r e s u l t i n g p r i c e i s a r b i t r a r y. P r i c i n g i n t e r m e d ia te goods a c c o rd in g to m ark e t p r i c e s h a s th e a d v an tag e o f m o tiv a tin g th e s u p p ly in g in v e s tm e n t c e n te r t o re d u c e i t s p ro d u c tio n c o s t a s much a s p o s s i b l e. I n a d d it i o n, m arket p r i c e s s e rv e t o s im u la te th e r e a l c o n d itio n s to w hich segm ents would be ex posed i f th e y were o rg a n iz e d a s s e p a r a te c o rp o r a te e n t i t i e s. F i n a l l y, u se o f t h i s form o f t r a n s f e r p r i c i n g sh o u ld a l i g n segm ent and c o rp o r a te i n t e r e s t s. T h is l a t t e r e f f e c t w i l l o c c u r i n c a s e s where 1. T r a n s f e r s m ust be made i f th e y i n c r e a s e th e p r o f i t o f th e c o r p o r a tio n a s a w hole, and 2. T r a n s f e r s m ust n o t be f o rc e d upon in v e s tm e n t c e n t e r s i f th e y re d u c e th e p r o f i t o f th e firm. I n b o th o f th e above c a s e s, w h a te v e r i n c r e a s e s th e p r o f i t o f an in v e s tm e n t c e n te r w i l l a l s o in c r e a s e th e p r o f i t o f th e e n t i r e fir m. However, i f th e s e c o n d itio n s a re to be m et, th e in v e s tm e n t c e n t e r s m ust be autonom ous and have a c c e s s t o w e ll-d e v e lo p e d e x t e r n a l m a rk e ts. To i l l u s t r a t e a p p l i c a t i o n o f th e above se g m en tal and c o rp o r a te co ngruency, c o n s id e r th e fo llo w in g i From th e p o i n t o f view o f th e b u y e r, i f th e p r i c e he m ust p ay i s th e same f o r i n s i d e and o u ts id e ^ P a u l W. Cook, Jr., ''D e c e n tr a liz a tio n and th e T ra n s- P r ic in g P ro b le m," J o u r n a l o f B u s in e s s. A p r il, 1955, p. 87.

139 p u r c h a s e s, h e c a n n o t "be f o r c e d t o a c c e p t a t r a n s f e r w h ic h w o u ld r e s u l t i n lo w e r p r o f i t s t h a n h e c o u ld e a r n b y p u r c h a s i n g e x t e r n a l l y. He w i l l a c c e p t i n t e r n a l t r a n s f e r s s o l o n g a s h e c a n p r o f i t a b l y u s e t h e g o o d s. T h u s, a n y t r a n s f e r w h ic h i n c r e a s e s h i s p r o f i t w i l l b e m a d e. C o n s id e r in g t h e sam e t r a n s a c t i o n fro m t h e s t a n d p o i n t o f t h e s e l l e r, i f h e c a n g e t t h e sam e p r i c e b y s e l l i n g t o a n o t h e r i n t e r n a l s e g m e n t t h a t h e c a n g e t b y s e l l i n g e x t e r n a l l y, h i s p r o f i t c a n n o t b e r e d u c e d b y m a k in g t h e t r a n s f e r i n t e r n a l l y. 4,0 125 N e g o t i a t i o n b a s e d t r a n s f e r p r i c i n g. I n t h e a b s e n c e o f a n e a s i l y d e t e r m in a b le t r a n s f e r m a r k e t p r i c e, n e g o t i a t e d p r i c e s o f t e n e m e r g e. T h is fo r m o f t r a n s f e r p r i c i n g, u s e d b y 3 3 p e r c e n t o f t h e r e s p o n d i n g f i r m s, i n v o l v e s a m u tu a l a g r e e m e n t b e t w e e n t h e t r a n s f e r o r a n d t r a n s f e r e e a s t o w h a t c o n s t i t u t e s a f a i r a n d r e a s o n a b l e t r a n s f e r p r i c e. H o w e v er, i f o u t s i d e m a r k e t r e f e r e n c e s do n o t a c t u a l l y e x i s t, a s i t u a t i o n c a l l e d b i l a t e r a l m o n o p o ly o c c u r s. T h is s i t u a t i o n a r i s e s w hen t h e b a r g a i n i n g r a n g e i s e x t r e m e l y w id e a n d t h e r e s u l t i n g t r a n s f e r p r i c e t e n d s t o i n d i c a t e n o t h i n g m ore t h a n who i s t h e m ore f o r c e f u l b a r g a i n e r. M o r e o v e r, i n a b i l a t e r a l m o n o p o ly s i t u a t i o n, t h e s e g m e n t s e i t h e r t r a n s f e r t h e i r g o o d s a n d s e r v i c e s i n t e r n a l l y o r t h e y s im p ly do n o t t r a n s f e r. I n a l l o t h e r c a s e s w h e r e n e g o t i a t i o n i s a p p l i e d, t h e p r im a r y a d v a n t a g e s t o i t s u t i l i z a t i o n a r e t h a t t h e p r o c e s s i n v o l v e d p r e s e r v e s t h e in d e p e n d e n c e o f t h e s e g m e n t m a n a g e r s a n d s e r v e s t o g u id e t h e s e g m e n t m a n a g e r i n h i s p u r c h a s in g and m a r k e t in g d e c i s i o n s. ^ 8I b i d.

140 126 C om bination o f m ark e t and n e g o ti a t e d p r i c e s. T h is p r i c i n g m ethod, w hich i s u t i l i z e d by 3 p e r c e n t o f th e r e sp o nding fir m s, in v o lv e s a n e g o ti a t e d a d ju s tm e n t o f th e e x te r n a l m ark et p r i c e i n o r d e r to r e f l e c t th e s u p p l i e r 's s a v in g s in d i s t r i b u t i o n, c r e d i t, c o l l e c t i o n, and o th e r e x p e n se s by s e l l i n g i n t e r n a l l y. T hese s a v in g s a llo w room f o r a downward n e g o ti a t e d a d ju s tm e n t o f th e p r e v a i l i n g e x te r n a l p r i c e. I t sh o u ld be n o te d t h a t th e i n c l u s i o n o f t h i s m ethod i s low p ro b a b ly b e c a u se th e q u e s tio n n a ir e d id n o t show t h i s p r i c i n g m ethod c h o ic e. I n sum m ary, i n t e r s e g m e n t a l p r i c i n g i s a m e a n s t o an e n d, n o t a n e n d i n i t s e l f. I t i s e s s e n t i a l t o a n y d e c e n t r a l i z e d p r o f i t c o n t r o l s y s t e m w h e r e s e g m e n t s b u y a n d s e l l i n t e r n a l l y. I t i s o b v io u s t h a t n o o n e m e th o d o f t r a n s f e r p r i c i n g c a n f u l f i l l a l l o f t h e n e e d s o f a c o r p o r a t i o n, b u t i n v ie w o f s p e c i f i e d g o a l s, c e r t a i n t r a n s f e r p r i c e s a r e b e t t e r t h a n o t h e r s. I t w o u ld a p p e a r fr o m t h e f o r e g o i n g d i s c u s s i o n t h a t t h e c o s t - b a s e d p r i c i n g s y s t e m s a r e b e t t e r a d a p t e d t o t h e n e e d s o f g e n e r a l f i n a n c i a l a c c o u n t i n g th a n t h e y a r e t o t h e n e e d s o f s e g m e n t a l p e r f o r m a n c e e v a l u a t i o n. C u r r e n t A s s e t D e l e t i o n s W ith t h e e x c e p t i o n o f c a s h, r e c e i v a b l e s, a n d i n v e n t o r y, m o s t o t h e r c u r r e n t a s s e t s a p p e a r in g on a s e g m e n t ' s b a la n c e s h e e t a r e n o t c o n s i d e r e d i n a r r i v i n g a t t h e s e g m e n t m anag e r 's in v e s t m e n t b a s e. A p r im e e x a m p le i s m a r k e t a b le s e c u r i t i e s a n o n o p e r a t i n g r e v e n u e g e n e r a t o r. N a t u r a l l y, t o

141 m a in ta in c o n s is te n c y, th e i n t e r e s t f a c t o r i s a ls o e lim in a te d from seg m en tal p r o f i t. 127 PLANT ASSET COMPONENT OF THE INVESTMENT BASE To w hat e x te n t can th e in v e s tm e n t i n f ix e d a s s e t s be re g a rd e d a s c o n t r o l l a b l e from th e segm ent m a n a g e r's p o in t o f view? The answ er to t h i s q u e s tio n depends on th e d e g re e o f autonom y w hich th e segm ent m anager e n jo y s r e l a t i v e to a s s e t a c q u s i t io n, u t i l i z a t i o n, and d i s p o s a l. As shown in TABLE 20 (page ), th e re s p o n d in g firm s i n d i c a t e t h a t th e i n c l u s i o n o f p l a n t a s s e t s i n th e m a n a g e r's in v e s tm e n t b a se i s d i c t a t e d more by th e r e l a t i o n s h i p o f an a s s e t to a p a r t i c u l a r segm ent th a n by m a n a g e ria l c o n tr o l o v e r th e a s s e t i n q u e s tio n. T his i s e v id e n c e d by th e f a c t t h a t a s s e t s u se d by m u ltip le segm ents and a s s e t s u s e d by c o rp o r a t e h e a d q u a r te r s o n ly a re b o th in c lu d e d i n th e in v e s tm e n t b a se by many firm s ; how ever, th e more i n d i r e c t th e a s s e t - t o - segm ent r e l a t i o n s h i p, th e lo w e r i s th e p e rc e n ta g e re s p o n s e o f b a se i n c l u s i o n. As su c h, p l a n t a s s e t s u se d by one segm ent o n ly a re in c lu d e d i n th e b a se by 98 p e r c e n t o f th e re s p o n d in g firm s w h ile p l a n t a s s e t s u se d by c o rp o r a te h e a d q u a rte r s a re in c lu d e d in th e b a se by o n ly 22 p e r c e n t o f th e s e same f ir m s. TABLE 20 a ls o r e v e a l s t h a t 83 p e r c e n t o f th e re s p o n d in g firm s u se n e t book v a lu e w h ile th e o th e r 1? p e r c e n t u se g r o s s book v a lu e (i.e., o r i g i n a l a s s e t c o s t) to v a lu e a s s e t s in c lu d e d i n th e in v e s tm e n t b a s e.

142 TABLE 20 ANALYSIS OF SEGMENTAL INVESTMENT BASE: PLANT ASSET SECTION QUESTIONNAIRE INQUIRY AND ASSET BASE RESPONSE A re p l a n t a s s e t s i n c l u d e d i n t h e se g m e n t b a s e i f u s e d : By o n e s e g m e n t o n l y?,... By tw o o r m ore s e g m e n t s?.. B y b o t h s e g m e n t ( s ) a n d c o r p o r a t e h e a d q u a r t e r s?. B y h e a d q u a r t e r s o n ly?... A re t h e f o l l o w i n g m e th o d s u s e d t o v a l u e p l a n t a s s e t s ( o t h e r t h a n la n d ) i n t h e in v e s t m e n t b a s e? G r o ss b o o k v a l u e (co st)... N e t b o o k v a l u e.... C u r r e n t r e p la c e m e n t c o s t... M a rk et o r a p p r a i s a l v a l u e.. O th e r b a s i s f o r v a l u a t i o n.. PLANT ASSET PORTION OF INVESTMENT BASE NOT APPLICABLE NO YES TOTAL FIRMS PERCENTAGE OF TOTAL # 7# TOTAL FIRMS PERCENTAGE OF TOTAL 2# 23# 38# 71# TOTAL FIRMS PERCENTAGE OF TOTAL I f n e t b o o k v a l u e a p p l i e s, i s t h e sam e o f d e p r e c i a t i o n u s e d i n t e r n a l l y a s i s u s e d f o r e x t e r n a l r e p o r t i n g p u r p o s e s? # # # 17# 100# 100# 100# # 54# 38# 22# 17# 83# TOTAL FIRMS 100# 215 SOURCE: C o r p o r a t io n s r e s p o n d in g t o q u e s t i o n n a i r e. 128

143 129 V a lu a tio n o f In c lu d e d P la n t A sse ts I f a l l p l a n t a s s e t s w ere p u rc h a se d a t th e b e g in n in g and r e t i r e d a t th e end o f th e p e rfo rm an c e e v a lu a tio n p e r io d th e p roblem s i n v a lu a tio n would n o t e x i s t. O b v io u sly, t h i s i s n o t th e c a se and v a lu a tio n d i f f i c u l t i e s r e l a t i v e to p l a n t a s s e t s do e x i s t. The p rim a ry problem i n d e te rm in in g what v a lu e to u se i s t h a t n e i t h e r g r o s s c o s t n o r n e t book v a lu e have any n e c e s s a ry r e l a t i o n s h i p to th e a s s e t 's o p e r a tin g e f f i c i e n c y v a lu e. In a d d i t i o n, b o th o f th e s e v a lu a tio n m ethods may c o n tr ib u te to m a n a g e ria l a c t io n s t h a t a r e n o t co n d u civ e t o th e i n t e r e s t o f th e o v e r a l l c o r p o r a t i o n. A c l o s e r e x a m in a tio n o f each v a lu a tio n m ethod fo llo w s I N et book v a lu e. N et book v a lu e i s p ro b a b ly so w id e ly u se d in v a lu in g f ix e d a s s e t s in th e b a se b e ca u se i t i s a r e a d i l y a v a i la b l e f ig u r e i n th e c o n v e n tio n a l a c c o u n tin g r e c o r d s. Most l i k e l y t h i s f a c t o r a ls o e x p la in s why ( a s shown in TABLE 20) 95 p e r c e n t o f th e re s p o n d in g firm s u t i l i z i n g n e t book v a lu e a p p ly th e same m ethods o f d e p re c i a t i o n in i n t e r n a l p erfo rm an ce e v a lu a tio n a s th e y do in e x te r n a l f i n a n c i a l r e p o r t i n g. As su ch, p ro c e d u re s b a se d on g e n e r a l l y a c c e p te d a c c o u n tin g p r i n c i p l e s te n d t o g o v e rn, o r a t l e a s t s i g n i f i c a n t l y in f lu e n c e, th e d e r i v a ti o n o f b o th th e segm ent m a n a g e r's p r o f i t and in v e s tm e n t b a s e. The s i g n i f ic a n c e o f t h i s f i n d in g stem s from th e f a c t t h a t th e r e s u l t i n g ROI and r e s i d u a l income c a l c u l a t i o n s may be

144 130 s e r i o u s l y d i s t o r t e d and th u s, i n a c c u r a t e l y r e f l e c t m anageri a l p e rfo rm a n c e. I n a d d it i o n, o p p o r t u n it i e s f o r seg m en tal s u b o p tim iz a tio n once a g a in em erge. The fo llo w in g d i s c u s sio n i s d e sig n e d to p ro v id e e v id e n c e r e l a t i v e t o th e p o in ts n o te d abovei The u se o f a n e t book v a lu e w hich in c o r p o r a te s conv e n tio n a l d e p r e c i a ti o n m ethods can r e s u l t i n th e fo llo w in g d y s f u n c tio n a l ROI and r e s i d u a l incom e e f f e c t s i 1. ROI and r e s i d u a l incom e w i l l b o th a u to m a tic a lly in c r e a s e sim p ly th ro u g h th e p a s s a g e o f tim e. T h is o c c u rs b e ca u se a s p l a n t a s s e t s a g e, n e t book v a lu e d e c l i n e s. The o v e r a l l e f f e c t i s a g g ra v a te d i f d e c lin in g b a la n c e m ethods o f d e p r e c i a ti o n a r e u se d b e c a u se n o t o n ly w i l l th e a s s e t b a se d e c re a s e a t a f a s t e r r a t e, b u t p r o f i t s w i l l a ls o in c r e a s e due to th e lo w er d e p r e c i a ti o n i n l a t e r y e a r s. 2. Assum ing th e above exam ple a p p li e s to one p l a n t a s s e t in i s o l a t i o n, what w ould be th e e f f e c t i f a segm ent h a s two i d e n t i c a l m ac h in e si One r e c e n t l y p u rc h a se d w h ile th e o th e r i s o n e - h a lf d e p r e c ia te d? The o v e r a l l e f f e c t i s t h a t b o th ROI and r e s i d u a l incom e w i l l be tw ic e a s h ig h f o r th e o ld e r m achine a s th e y a r e f o r th e new er o n e. T his r e s u l t i s i l l o g i c a l i f one i s a tte m p tin g to m easure manag e r i a l e f f i c i e n c y i n o p e r a tio n s. I n summary, m a n a g e ria l o p e r a tin g r e s u l t s sh o u ld n o t be d i s t o r t e d by th e age o f an a s s e t e x c e p t to th e e x te n t t h a t a s s e t age a f f e c t s th e o p e r a tin g e f f i c i e n c y o f th e

145 re s o u rc e th ro u g h p o o r e r p e rfo rm an c e o r h ig h e r m ain ten a n ce 131 c o s t s. I n such s i t u a t i o n s, a lo w e r ROI and r e s i d u a l income sh o u ld r e s u l t a s th e a s s e t becom es o l d e r. In t h i s r e s p e c t, none o f th e d e p r e c ia tio n m ethods g e n e r a l l y a c c e p ta b le i n e x te r n a l f i n a n c i a l r e p o r t i n g a re a d a p te d to m eet t h i s m easurem ent n e e d. S e v e ra l exam ples a re now c i t e d i n o r d e r t o show how n e t book v a lu e can a ls o le a d t o su b o p tim a l segm ent m anager d e c is io n a c t io n : 1. U t i l i z i n g n e t book v a lu e, i t i s p o s s ib l e to a c h ie v e an ROI o f i n f i n i t y i f a s s e t s become f u l l y d e p re c i a t e d b u t a r e s t i l l c a p a b le o f p ro d u c in g an a d e q u a te in co m e.^9 Thus, s in c e b o th ROI and r e s i d u a l incom e in c r e a s e a s a s s e t s become o ld e r, new in v e s tm e n t an d, t h e r e f o r e, c o rp o ra te grow th te n d t o be d is c o u ra g e d. The u s e o f r e s i d u a l incom e, how ever, p a r t i a l l y r e s o lv e s t h i s d i f f i c u l t y by e n c o u ra g in g new in v e s tm e n t i f i t s e x p e c te d r e t u r n exceed s i t s c h a rg in g ra te * b u t th e f a c t s t i l l re m a in s t h a t n e t book v a lu e w eakens t h i s m o tiv a tio n r e g a r d l e s s o f th e m easurem ent t o o l t h a t i s a p p lie d. 2. An a d v a n ta g e f r e q u e n t ly c i t e d f o r th e u s e o f n e t book v a lu e i s t h a t do u b le c o u n tin g i n th e in v e s tm e n t b ase i s a v o id e d. Double c o u n tin g w ould o th e rw is e r e s u l t b e ca u se i t i s assum ed t h a t th e p o r t i o n o f o r i g i n a l c o s t r e p r e s e n te d ^ M a u r i e l and A nthony, op. c it., p. 103.

146 by d e p r e c i a ti o n w r i t e o f f s i s s u b s e q u e n tly r e i n v e s t e d in o th e r a s s e t s by th e segm ent m anager and, t h e r e f o r e, i s in c lu d e d i n h i s b a se i n t h i s a l t e r n a t i v e f o r m. -50 Even i f t h i s a s s e r t i o n i s v a l i d, t h e r e i s n o th in g to m o tiv a te th e segm ent m anager in th e d i r e c t i o n o f r e i n v e s t i n g fu n d s g e n e r a te d th ro u g h d e p r e c i a t i o n. FIGURE 7 (page 133) i l l u s t r a t e s t h i s p o i n t by com paring two c a s e s where c o n tr o l o f d e p r e c i a ti o n fu n d s i s v e s te d i n th e segm ent m anager. I n th e f i r s t c a s e, managem ent r e i n v e s t s th e s e fu n d s a t an a n n u a l r a t e o f 10 p e r c e n t w h ile i n th e second c a se th e s e fu n d s a r e h e ld i n th e segm ent a s cash r e s e r v e s, w hich r e s u l t s i n a r e in v e s tm e n t r a t e o f z e r o. I n b o th c a s e s, a c o n s ta n t a n n u a l e a r n in g s r a t e o f 10 p e r c e n t i s assum ed f o r th e p l a n t a s s e t h e ld th ro u g h o u t th e f i v e - y e a r p e r i o d. FIGURE 7 p o i n t s o u t th e f a c t t h a t a lth o u g h t h e r e i s some m o tiv a tio n f o r th e segm ent m anager to r e i n v e s t fu n d s (C ase 1 ), he i s n o t a c t u a l l y p e n a liz e d i f h'* f a i l s to do so (C ase 2 ). Such a b e h a v io r a l r e a c t i o n i s c l e a r l y d y s f u n c tio n a l from an o v e r a l l c o rp o r a te v ie w p o in t. 3. F i n a ll y, when u n i t ( a s opposed to co m p o site) d e p r e c i a ti o n i s a p p lie d, an a d d i t i o n a l su b o p tim a l e f f e c t may be th e p re m a tu re d i s p o s a l o f p ro d u c tiv e p l a n t a s s e t s i n y e a r s when th e s e a s s e t s a re i d l e o r when t h e i r r e t u r n r a t e i s l e s s th a n s a t i s f a c t o r y i n th e s h o r t r u n. ^ H aro ld R. Lammie, "R e tu rn on C a p ita l E m ployed," The J o u r n a l o f A cco u n tan cy. 106 (A u g u st, ), 36.

147 133 Y ear E nding 1 N et A sse t V alue $ A ccum ulated D e p re c ia tio n 200 T o ta l A sse t C ost $ $ 6oo $ 400 $ 200 $ ,000 $1,000 $ $*! 000 $1,000 CASE l i DEPRECIATION FUNDS REINVESTED AT 10# O rig. A sse t Incom e $ D e p r e c ia tio n R e in v e stm en t E a rn in g s 20 T o ta l Incom e R01 12# $ 100 $ 100 $ 100 $ o $_ l4 0 $ $ # 16* 18# 20# CASE 2 1 DEPRECIATION FUNDS HELD AS CASH RESERVES AT 0# Orig* A sse t Incom e $ 100 $ 100 $ D e p re c ia tio n R ein v estm en t E a rn in g s T o ta l Incom e $ 100 $ 100 $ 100 ROI 10# 10# 10# $ 100 $ 100 $ 100 ^ # 10# FIGURE 7 MANAGERIAL REINVESTMENT DECISIONS AND ROI UNDER NET BOOK VALUE SOURCEi T erb o rg h, op. c i t. # p p

148 G ross a s s e t c o s t. The m ost im p re s s iv e argum ent f o r th e u se o f g r o s s c o s t i s t h a t i t e li m in a te s th e e f f e c t s o f im p e rfe c t d e p r e c i a ti o n m ethods from th e in v e s tm e n t b a s e. However, some a u th o r s w ould a rg u e t h a t t h i s a ls o r e s u l t s i n d o u b le c o u n tin g th e a s s e t s in c lu d e d i n th e in v e s tm e n t b a se due to th e r e in v e s tm e n t o f re c o v e re d d e p r e c i a t i o n. 5^- When re in v e s tm e n t does o c c u r g r o s s c o s t, u n l ik e n e t book v a lu e, w i l l te n d t o e n co u rag e th e segm ent m anager to u n d e r ta k e th e m ost p r o f i t a b l e r e in v e s tm e n t o p p o r tu n ity. To i l l u s t r a t e th e e f f e c t o f t h i s change FIGURE 8 (p ag e 135) r e s t a t e s, w ith p r o p e r a d ju s tm e n t, th e two c a s e s p r e v io u s ly p r e s e n te d in FIGURE 7 (p ag e 133)» u s in g g r o s s book v a lu e. FIGURE 8, Case 1 c l e a r l y shows t h a t i f th e r e in v e s tm e n t r a t e e q u a ls th e o r i g i n a l e a rn in g s r a t e ( i. e., b o th e q u a l 10 p e r c e n t ), ROI w i l l rem a in c o n s ta n t. T h is e f f e c t d i f f e r s from th e r e s u l t s shown i n FIGURE 7> Case 1 w here ROI in c r e a s e d b u t th e r e in v e s tm e n t r a t e was no m ore p r o f i t a b l e th a n th e o r i g i n a l e a r n in g s r a t e. FIGURE 8, Case 2 u n lik e Case 2 i n FIGURE 7 shows t h a t u n p r o f i t a b l e h o ld in g o f cash r e s e r v e s i s p e n a liz e d u s in g g ro s s book v a l u a t i o n. T h e re fo re, th e u se o f g ro s s c o s t ( a s opposed to n e t book v a lu e ) w i l l r e s u l t i n th e m anager's r e a l o p e r a tin g p e rfo rm a n c e b e in g p r o p e r ly shown r a t h e r th a n b e in g o v e r s t a t e d. U n fo rtu n a te ly, a s i s th e c ase w ith n e t book v a lu e, th e o p p o r tu n ity f o r - ^ I. Wayne K e l l e r, "The R e tu rn on C a p ita l C o n c e p t," N.A.A. B u l l e t i n, 39 (M arch, 1958), 16.

149 135 Y ear E nding G ross A sse t C ost $ 1,0 0 0 $ 1,0 0 0 $ 1,0 0 0 $ 1,0 0 0 $ 1,000 + A ccum ulated D e p re c ia tio n T o ta l G ross A s s e ts CASE I t DEPRECIATION FUNDS REINVESTED AT 10# O rig. A sse t Incom e $ 100 $ 100 $ 100 $ 100 $ D e p re c ia tio n R ein v estm en t E a rn in g s T o ta l Income ROI 10% CASE 2 i DEPRECIATION FUNDS HELD AS CASH RESERVES AT 0# O rig. A sse t Incom e $ 100 $ 100 $ 100 $ 100 $ D e p re c ia tio n R ein v estm en t E a rn in g s T o ta l Income L _. i L = = = = RCI S* 5 H FIGURE 8 MANAGERIAL REINVESTMENT DECISIONS AND ROI UNDER GROSS BOOK VALUE SOURCEi T erb o rg h, i b i d., p. 4 6.

150 136 c o rp o r a te s u b o p tim iz a tio n can s t i l l a r i s e. T h is s i t u a t i o n o c c u rs b e ca u se by u t i l i z i n g g ro s s c o s t v a lu a ti o n i 1, I t i s p o s s ib l e f o r a segm ent m anager t o in c r e a s e b o th h i s ROI and r e s i d u a l incom e by s c ra p p in g p e r f e c t l y u s e f u l a s s e t s ( th e in v e s tm e n t b a se i s re d u c e d by th e a s s e t 's c o s t ), and 2, I n th e case o f a s s e t re p la c e m e n ts, g r o s s c o s t v a lu a ti o n c a u se s an i n c o n s i s t e n t r e a c t i o n betw een segm ent and c o rp o ra te r e s u l t s. T h is in c o n s is te n c y a r i s e s b ecau se when a s s e t s a re r e p la c e d, g r o s s c o s t i n th e segm ent b a se w i l l i n c r e a s e by th e d i f f e r e n c e betw een th e o r i g i n a l c o s t o f th e o ld and th e a c q u s i t io n c o s t o f th e new a s s e t s. T h is r e a c t i o n i s i n c o n t r a s t to th e c o rp o ra te change i n t h a t th e re p la c e m e n t c o s t t o th e firm i s e q u a l to th e c o s t o f th e new a s s e t l e s s th e sa lv a g e v a lu e o f th e o ld a s s e t. F u r th e r m ore, sa lv a g e v a lu e i s g e n e r a l l y f a r lo w e r th a n th e o r i g i n a l c o s t o f th e o ld a s s e t, and s u b o p tim iz a tio n o c c u rs when segm ent re p la c e m e n ts below th e o v e r a l l c o rp o ra te e a rn in g s r a t e im proves th e segm ent m a n a g e r's r a t e o f r e t u r n. ^ I n o rd e r to t e s t th e s e n s i t i v i t y o f th e ROI p a ra m e te r v a lu e s i n TABLE 16 (page 107) r e g a r d in g p l a n t a s s e t r e p la c e m ent d e c is io n s, th e fo llo w in g two s i t u a t i o n s w ere a d a p te d to th e firm p a r t i c i p a t i n g in th e s e n s i t i v i t y a n a l y s i s u se d in t h i s stu d y i -^A nthony, D earden, and V a n c il, op. c i t,, p. 3^0 and D earden, "Case A g a in st ROI C o n tr o l," op. c i t., p. 127.

151 137 I n th e f i r s t t e s t, i t was assum ed t h a t $952,000 i n o b s o le te d e p r e c ia b le p l a n t a s s e t s w ere r e p la c e d i n each p r o d u c t - l i n e segm ent d u rin g 1974 a t an a v e ra g e re p la c e m e n t c o s t o f 20 p e r c e n t above th e a s s e ts * o r i g i n a l a c q u s i t io n c o s t s. I n th e n e t book v a lu e ROI c a l c u l a t i o n s, th e a c c u m u la te d d e p r e c i a ti o n on th e a s s e t s to be r e p la c e d was assum ed to ap p ro ach th e a v e ra g e d e p r e c i a ti o n o f a l l a s s e t s i n each p r o d u c t - l in e segm ent ( i. e., p l a s t i c s 2l?S, c h e m ic a ls 50#, and s y n t h e t i c s 5 # ) To th e i n d u s t r i a l p ro d u c t g roup a s a w hole, th e n, th e t o t a l c o s t o f th e a s s e t s to be r e p la c e d was $ 2,8 ^ ( i. e., $952,0 0 0 x 3 ). The second t e s t was s i m i l a r to th e above e x c e p t t h a t in each p r o d u c t - l i n e segm ent 42 p e r c e n t o f th e d e p re c ia b le p l a n t a s s e t s w ere o b s o le te and r e q u ir e d re p la c e m e n t. T h e re fo re, th e o r i g i n a l c o s t o f a s s e t s to be r e p la c e d i n each p r o d u c t - l in e segm ent am ounted to I A ll o th e r f a c t o r s p r e v io u s ly assum ed w ith r e s p e c t to th e f i r s t re p la c e m e n t t e s t rem ain ed th e same f o r p u rp o s e s o f t h i s second t e s t. The r e s u l t s o f th e above two t e s t s a re shown i n TABLES 21 and 22 (p ag e s 138 and 139)«As i n d ic a t e d by a com parat i v e a n a l y s i s o f th e s e two t a b l e s, th e fo llo w in g r e l a t i o n s h ip s emerge* P l a s t i c s C hem icals S y n th e tic s T o ta l P ro d u c t-g ro u p - = $ 798,000 = 1, 638,000 = W ith u n ifo rm d o l l a r re p la c e m e n t, th e s y n t h e ti c s s e c t o r ROI r e s u l t s a re th e m ost s e n s i t i v e w h ile th e chem i c a ls s e c t o r ROI r e s u l t s a re th e l e a s t a f f e c t e d. The re a so n f o r t h i s o v e r a l l r e a c t i o n i s t h a t i n th e s y n t h e t i c s a re a, v i r t u a l l y a l l o f i t s p l a n t a s s e t s a re r e p la c e d w h ile in th e c h e m ic a ls s e c t o r, o n ly o n e - t h i r d o f i t s a s s e t s a re a f f e c t e d. However, when t h i s com parison i s b a se d on th e s e n s i t i v i t y o f ROI betw een b o o k -v a lu e -b a s e d ROI and

152 TABLE 21 SENSITIVITY OF ROI ASSUMING UNIFORM DOLLAR PLANT ASSET REPLACEMENT BASE CONTRIBUTION MARGIN PROFIT BASE PERFORMANCE MARGIN SEGMENT MARGIN INCOME BEFORE TAXES INDUSTRIAL PRODUCT-GROUP INVESTMENT CENTERS INCOME AFTER TAXES Plant Assets 0 BV -23.1# -12.9# -11.7# -10.4# -5.3# Plant Assets 0 Cost # - 2.8# - 2.6# - 2.3# -1.2# Plant Assets 9 BV + v ;c # - 4.6# - 4.2# - 3.7# -1.9# Plant Cost + VJC # - 1.3# - 1.2# - 1.0# -0.5 # Total Assets 9 BV 1-2.6# - 2.4# - 2.1# -1.1 # Total Assets 9 CoSt.... a - 1.5# - 0.8# - 0.7# - 0.6# -0.3# CO INDUSTRIAL PLASTICS PRODUCT-LINE SEGMENT Plant Assets 9 BV -22.4# - 8.0# - 7.7# - 7.0# -3.9 # Plant Assets 0 Cost # - 2.7# - 2.6# - 2.3# -1.2# Plant Assets 9 BV + WC # - 6.3# - 6.1# - 5.5# -3.0 # Plant Assets 9 Cost + VJC # - 2.2# - 2.1# - 1.9# -1.0# Total Assets 9 BV - 7.7# - 2.8# - 2.6# - 2.4# -1.3# Total Assets 9 Cos t # - 1.0# - 1.0# - 0,9# -0.5# INDUSTRIAL Gl'l'.i l SALS PRODUCT-LINE SEGMENT P la n t A ssets 9 BV -22.2# -16.3# -14.6# -13.3# -6.3# P la n t A ssets 9 C ost # - 1.5# - 1.3# - 1.2# -0.5# P la n t A ssets 9 BV + VJC # - 5.7# - 5.1# - 4.6# -2.2# P la n t A ssets 0 Cost + VJC # - 0.6# - 0.6# -0.3# T o tal A ssets 9 BV - 4.6# - 3.4# - 3.0# - 2.7# -1.3# T o tal A ssets 0 Cost ?# - 0.5# - 0.4# - 0.4# -0.2# 1 0 * INDUSTRIAL SYNTHETICS PRODUCT- LINE SEGMENT P la n t A ssets 0 BV # -17.8# -16.7# -13.8# -7.1# P la n t A ssets 0 C o st... * # -13.5# -11.9# -10.5# -5.4 # P la n t A ssets 0 BV t VJC # - 2.6# - 2.3# - 2.0# -1.0# P la n t A ssets 0 C ost + WC # - 2.0# - 1.8# - 1.6# -0.8# T o ta l A ssets 0 BV - 3.1# - 1.7# - 1.5# - 1.3# -0.6 # T o ta l A ssets 0 C o st # - 1.3# - 1.2# - 1.0# -0.5# SOURCEi C o r p o r a tio n p a r t i c i p a t i n g in s e n s i t i v i t y s t u d y.

153 INVESTMENT BASE TABLE 22 SENSITIVITY OF ROI ASSUMING UNIFORM PERCENTAGE PLANT ASSET REPLACEMENT CONTRIBUTION MARGIN PROFIT BADE PERFORMANCE MARGIN SEGMENT MARGIN INDUSTRIAL PRODUCT-GROUP INVESTMENT CENTERS INCOME BEFORE TAXES INCOME AFTER TAXES Plant Assets 0 BV -26.8# * -13.4# ?: -6.2% Plant Assets 0 Cost* «* * /1-2.9 % - 2.6% - 1.2% Plant Assets 0 BV + WC»»» * - 9.8?! % - 5.0% - 4.4?* -2.2% Plant Assets 9 Coot + wc % % - 1.2% - i.i?: - 0.5% Total Assets BV - 3.7?: - 3.2% % - 2.6?: % Total Assets Cost - 1.5?: - 0.8% - 0.7% ?: % 1 ro TNDUIiTRlAL PLASTICS PRODUCT-LINE SEGMENT Plant Assets 3V -19.5?: S - 6.7'/ - 6,o?s -3.47* Plant Assets Cost* *.. * * - 6.4u* * - 2.2?S : -1.17S Plant Assets 9 BV t li'c SS : % ?: ?: Plant A ssets 9 Cost + WC % * % : -o.9?s Total A ssets 9 BV * - 2.4?5-2.3 % - 2.o?s -l.lfs Total Assets 0 Cost* * * * * * % : - 0.8% ?: -o.4?s INDUSTRIAL CHEMICALS PRODUCT-LINE SEGMENT Plant Assets BV : : % ?5-9.2?S Plant Assets 0 Cost. * * ?* : - 2.2% ?: -0.9?: Plant Assets 0 BV + WC ?: - 8,8?: % ?: -3.4?: Plant Assets 9 Cost + VJC * : - 1.3?: % s % Total Assets 0 BV ?: : * ?: ! Total Assets 0 Cost ?: % % I O *>3 INDUSTRIAL SYNTHETICS PRODUCT-LINE SEGMENT % Plant Assets 0 BV * * % * % Plant A ssets 0 Cost * - 6.4?* % * % Plant A ssets 0 BV + VJC ?: % % ?* -0.4# Plant A ssets 9 Cost + VJC * - 0.9% S * Total A BV ,-: - 0.7% :.: - 0.6?: -0.37* Total A ssets Cost : - 0.6% -0.5?* - 0.4?: -0,27* SOURCEi C o r p o r a tio n p a r t i c i p a t i n g in s e n s i t i v i t y s t u d y. 1 O

154 c o s t- b a s e d ROI, th e o p p o s ite s e n s i t i v i t y r e l a t i o n s h i p w i l l 1*K> a r i s e. T h is l a t t e r r e s u l t o c c u rs b e c a u se when com paring g r o s s c o s t and n e t book v a lu e b a se d R O I's, th e segm ent w ith th e o l d e s t a s s e t s (c h e m ic a ls ) w i l l e x p e rie n c e th e g r e a t e s t in c r e a s e in i t s book v a lu e b a se due to th e l a r g e acc u m u late d d e p r e c ia tio n b a la n c e t h a t m ust be r e l i n q u is h e d in th e re p la c e m e n t p r o c e s s. 2. W ith u n ifo rm p e rc e n ta g e re p la c e m e n t, th e segm ent w ith th e lo w e st amount o f p l a n t a s s e t s w i l l be th e l e a s t a f f e c t e d. T h e re fo re, ROI r a t e s e n s i t i v i t y i s g r e a t e s t i n th e c h e m ic a ls segm ent and low eb t in th e s y n t h e t i c s segm ent. T h is r e l a t i o n s h i p i s th e same even i f th e com p ariso n i s g r o s s c o s t v e rs u s n e t book v a lu e b a se d ROI*s. 3. F or th e i n d u s t r i a l p ro d u c t gro u p a s a w hole, th e R O I's b a se d on g r o s s c o s t p o s s e s s th e same s e n s i t i v i t y i n b o th th e u n ifo rm p e rc e n ta g e and u n ifo rm d o l l a r re p la c e m e n t t e s t s, b u t th e s e s e n s i t i v i t y r a t e s d i f f e r f o r th e n e t-b o o k - v a lu e - b a s e d R O I's. In t h i s r e s p e c t, th e s e n s i t i v i t y i s g r e a t e r in th e u n ifo rm p e rc e n ta g e t e s t due to th e h ig h e r d e g re e o f in f lu e n c e o f re p la c e m e n ts i n th e c h e m ic a ls p r o d u c t - l in e s e c t o r. T h is f a c t o r p r o v id e s f u r t h e r e v id e n c e to s u p p o rt th e c o n te n tio n t h a t th e m ere age o f a s s e t s a s opposed to t h e i r r e l a t i v e o p e r a tin g e f f i c i e n c y a f f e c t s th e s e n s i t i v i t y o f a n e t- b o o k - v a lu e - b a s e d ROI d e te r m in a tio n. A lthough i t h a s n o t been i l l u s t r a t e d i n th e above t e s t s, v i r t u a l l y th e same d o l l a r r e s u l t s i n te rm s o f s e n s i t i v i t y d i r e c t i o n w ould r e s u l t i f r e s i d u a l incom e

155 lkl r a t h e r th a n ROI was th e t o o l e v a lu a te d. Thus, r e s i d u a l income i s no b e t t e r th a n ROI i n e v a l u a t i n g m a n a g e ria l e f f e c t i v e n e s s when p l a n t a s s e t s a t g r o s s o r n e t book v a lu e a re in c lu d e d i n th e in v e s tm e n t b a s e. P la n t A sse t V a lu a tio n A d ju stm en ts The i n e q u i t i e s cau se d by g r o s s c o s t and n e t book p l a n t a s s e t v a lu a ti o n s a re re d u c e d by in c lu d in g a s s e t s in th e segm ent m a n a g e r's in v e s tm e n t b a se a t re p la c e m e n t c o s t. A lthough no firm s i n th e p r e s e n t q u e s tio n n a ir e s tu d y u se t h i s a l t e r n a t i v e form o f v a lu a ti o n, i t i s a v a lu a ti o n m ethod u t i l i z e d by some c o r p o r a t i o n s. ^ W hile t h i s m ethod o f v a lu a tio n p r o v id e s f o r th e e q u a l i z a t i o n o f d o l l a r v a lu e s, i t makes no d i s t i n c t i o n betw een o l d e r f a c i l i t i e s and equipm ent t h a t may be l e s s e f f i c i e n t i n se g m e n ta l o p e ra t i o n s. P la n t A sse t A d d itio n s I n c e r t a i n c a s e s, th e p l a n t a s s e t b a se m ust be m o d ifie d by a d d in g "m issin g a s s e t s " i n o rd e r f o r th e r e s u l t s to r e f l e c t t o t a l c o n t r o l l a b l e o p e r a tin g r e s o u r c e s. A cco rd in g ly, a d i s t o r t e d and u n r e a l i s t i c ROI and r e s i d u a l incom e w i l l r e s u l t i f p l a n t a s s e t s a re le a s e d i n s t e a d o f owned by th e ^ N a t i o n a l A s s o c ia tio n o f A c c o u n ta n ts R e se arch R eport Number 35, op. c i t., p. 11. T h is s tu d y i n d ic a t e d t h a t 2 o u t o f b2 com panies in c lu d e d in i t s a n a l y s i s a d ju s te d p l a n t a s s e t v a lu a t i o n to r e f l e c t c u r r e n t re p la c e m e n t a s s e t c o s t.

156 in v e s tm e n t c e n t e r s. The e x te n t t o w hich p e rfo rm an c e d i s t o r t i o n can o c c u r i s d e m o n s tra te d i n th e fo llo w in g t e s t 142 s i t u a t i o n w hich was a d a p te d to th e c o r p o r a tio n p a r t i c i p a t i n g in th e s e n s i t i v i t y a n a l y s i s i I t was assum ed t h a t th e c h e m ic a ls p r o d u c t - l i n e i n d u s t r i a l segm ent h ad o r i g i n a l l y le a s e d i n s t e a d o f p u rc h a s e d 50 p e r c e n t ( i. e., $ 1, 9 5 0, ) o f i t s d e p re c ia b le p l a n t a s s e t s a t an a n n u a l l e a s i n g c o s t o f $ 2 0 0, The le a s e d a s s e t s w ere n o t c a p i t a l i z e d i n th e in v e s tm e n t b a se b u t th e a n n u a l l e a s i n g c o s t was d e d u c te d in p r o f i t d e r i v a t i o n. The o r i g i n a l d a ta p r e s e n te d i n TABLES 2 and 3 was a d ju s te d t o r e f l e c t th e above t e s t s i t u a t i o n. The e f f e c t o f t h i s l e a s i n g t e s t on th e ROI p a ra m e te r v a lu e s shown i n TABLE 16 (p ag e 107) i s p r e s e n te d in TABLE 2 3 (page ). The o v e r a l l r e s u l t i s a s i g n i f i c a n t i n c r e a s e i n b o th th e i n d u s t r i a l p ro d u c t g r o u p 's and c h e m ic a ls s e g m e n t's ROI r a t i o s. T h is e f f e c t o c c u rs b e c a u se l e a s i n g i s g e n e r a l l y l e s s e x p e n siv e to th e segm ent th a n o u t r i g h t p u rc h a s in g o f p l a n t a s s e t r e s o u r c e s ; how ever, th e n e a r e r th e l e a s i n g i n t e r e s t r a t e i s to th e r a t e o f r e t u r n w hich th e a s s e t i s c a p a b le o f e a r n in g i n o p e r a tio n s, th e l e s s d i f f e r e n c e w i l l th e s u b s t i t u t i o n o f le a s e d a s s e t s f o r owned a s s e t s ( o r v ic e v e rs a ) make i n th e d e r i v a ti o n o f ROI o r r e s i d u a l incom e. To th e e x te n t t h a t r a t e e q u a l i t y does n o t e x i s t and th e in v e s tm e n t c e n t e r m anager h a s th e a u th o r i t y to make th e le a s e - o r - b u y d e c is io n, i t n o rm a lly i s to h i s own b e s t i n t e r e s t to l e a s e a s much a s p o s s ib l e even i f from th e c o r p o r a t i o n 's view i t w ould be b e t t e r t o b u y.- ^ ^ M a u r i e l and A nthony, op. c i t., p. 104

157 143 TABLE 23 SENSITIVITY OF ROI ASSUMING THAT THE CHEMICALS SEGMENT ORIGINALLY LEASED 50 PERCENT OF ITS PLANT ASSETS INVESTMENT BASE CONTRIBUTION MARGIN PROFIT BASE PERFORMANCE MARGIN SEGMENT MARGIN INCOME BEFORE TAXES INCOME AFTER TAXES INDUSTRIAL PRODUCT-GROUP INVESTMENT CENTER P l a n t A sse BV ? # # # + ^.7 # P la n t A s s e C o st # # # + 4,8 # P la n t A s s e ts e BV + WC $ # # # # P la n t A s s e C ost + WC # # # # # T o ta l A s s e BV # # # # # T o ta l A s s e C o st # + 2. ^ # # INDUSTRIAL CHEMICALS PRODUCT-LINE SEGMENT P la n t A sse ts BV # # # # # P la n t A sse ts C ost # # # # P la n t A sse BV + WC # # # # # P la n t A sse ts Cost + WC # # # # T o ta l A ss e ts BV # # # # # T o ta l A sse ts Cost # # # # # SOURCE* a n a l y s i s. C o rp o ra tio n p a r t i c i p a t i n g i n s e n s i t i v i t y

158 Ikk As such, an a d d i t i o n a l o p p o r tu n ity f o r c o rp o r a te su b o p tim i z a tio n can a r i s e i n th e c ase o f n o n c a p i ta l iz e d lo n g -te rm l e a s i n g a rra n g e m e n ts. The e x te n t to w hich th e c o r p o r a tio n s re s p o n d in g t o th e q u e s tio n n a ir e in c lu d e le a s e d a s s e t s in se g m e n ta l b a se d e t e r m in a tio n i s shown i n TABLE 2k (p ag e 1^5) In a com parison betw een e x te r n a l and i n t e r n a l l e a s i n g s o u rc e s, an i n t e r e s t in g f a c t i s r e v e a le d, nam ely, t h a t many firm s l e a s i n g from b o th i n t e r n a l and e x te r n a l s o u rc e s in c lu d e o n ly th e e f f e c t s o f e x te r n a l l e a s e s a s c a p i t a l i z e d i n th e b a s e. P o s s ib ly t h i s in c o n s is te n c y can be e x p la in e d by n o tin g t h a t g e n e r a l l y a c c e p te d a c c o u n tin g p r i n c i p l e s p r e s e n t l y r e q u i r e t h a t le a s e d a s s e t s be c o n s tru e d a s owned ( o r p u rc h a se d ) r e s o u rc e s, and th u s s u b je c t to c a p i t a l i z a t i o n, where th e l e a s i n g arran g em en t i s lo n g term i n n a t u r e. T h is re q u ire m e n t, how ever, does n o t e x te n d to i n t e r n a l l e a s i n g s o u rc e s, a s th e s e i n t e r n a l e f f e c t s would be e lim in a te d in th e d e t e r m in a tio n o f c o rp o r a te c o n s o lid a te d t o t a l s. The p o s i t i o n ta k e n in t h i s stu d y i s t h a t l e a s i n g so u rc e i s im m a te ria l, and i f th e l e a s e - o r - b u y d e c is io n i s c o n t r o l l a b l e by th e segm ent m anager, lo n g -te rm le a s e d r e s o u r c e s sh o u ld be c a p i t a l i z e d in th e in v e s tm e n t b a s e. The fo llo w in g s e r v e s to j u s t i f y t h i s n e ed f o r i n c l u s i o n o f c o n t r o l l a b l e le a s e d r e s o u r c e s in th e a s s e t b a s e i I f one i s e v a lu a tin g th e o p e r a tin g e f f i c i e n c y o f two segm ent m anagers and one m anager p u rc h a s e s h i s equipm ent w h ile th e o th e r m anager l e a s e s th e same i d e n t i c a l equipm ent, th e n t h e same o p e r a tin g r a t e o f

159 TABLE 2k ANALYSIS OF SEGMENTAL INVESTMENT BASE» ROLE OF LEASED ASSETS QUESTIONNAIRE INQUIRY AND LEASED ASSETS RESPONSE LEASED ASSETS NOT APPLICABLE NO YES TOTAL FIRMS PERCENTAGE OF TOTAL TOTAL FIRMS PERCENTAGE OF TOTAL TOTAL FIRMS PERCENTAGE OF TOTAL KSESSB^S TOTAL FIRMS 100# Are le a s e d a s s e t s in c lu d e d i n a se g m e n t's re s o u rc e b a se i f th e y a r e i L eased from o th e r segm ents w ith in th e firm?.... L eased from o th e r firm s? k 11# CM D # 32# 215 V a lu a tio n i n b a se o f in c lu d e d le a s e d a s s e ts * C a p ita liz e d v a lu e o f l e a s e h o ld... E stim a te d O rig in a l c o s t o r s i m il a r m easure.. N et book v a lu e As a s p e c i f i c m u ltip le o f a n n u al l e a s in g c o s t N et p r e s e n t v a lu e # 16# 34# 2# 1# 77* T o ta l Response to L ea sin g Base I n c l u s i o n # 1 77 SOURCEi C o rp o ra tio n s re sp o n d in g to q u e s tio n n a ir e. Out o f 215 firm s, 25 firm s le a s e from b o th i n t e r n a l and e x te r n a l so u rc e s; how ever, o n ly 13 o u t o f th e s e 25 firm s in c lu d e th e e f f e c t s o f b o th ty p e s o f l e a s in g i n a segm ent's b a s e, w h ile th e o th e r 12 firm s in c lu d e i n th e b ase e x te r n a l l e a s e s o n ly. T h e re fo re, 77 firm s in c lu d e some form o f le a s e d a s s e t s in a se g m e n t's re s o u rc e b a se (77 = 90-13).

160 146 r e t u r n o r r e s i d u a l incom e sh o u ld be e x p e c te d, a l l o th e r p e rfo rm an c e f a c t o r s b e in g e q u a l. However, i f th e le a s e d equipm ent i s n o t c a p i t a l i z e d, q u i t e d iv e r g e n t p e rfo rm an c e r e s u l t s w i l l em erge. To e lim in a te th e p o s s i b i l i t y o f t h i s d i s t o r t i o n o c c u rr in g, b o th a s s e t s sh o u ld be c o n s id e re d a s i d e n t i c a l. T h is r e q u i r e s t h a t th e le a s e d equipm ent be in c lu d e d i n th e in v e s tm e n t b a se a s an em ployed a s s e t r e s o u r c e.55 W ith r e s p e c t to th e v a lu a ti o n b a se o f c a p i t a l i z e d le a s e d a s s e t s, TABLE 24 shows th e v a lu a tio n m ethods u se d by th e re s p o n d in g c o r p o r a t io n s. The m ethod o f c a p i t a l i z i n g th e v a lu e o f th e l e a s i n g p ay m en ts u se d by 4? p e r c e n t o f th e s e f ir m s i s c o m p le te ly v a l i d o n ly i f th e p e r io d o f th e l e a s e a rra n g em e n t i s e q u a l to th e e x p e c te d l i f e o f th e le a s e d a s s e t. A ll o th e r l i s t e d m ethods a re a t b e s t m ere a p p ro x im a tio n s o f t h i s v a lu e. I t was s u r p r i s i n g t o n o te t h a t none o f th e firm s l i s t e d a s s e t c a p i t a l i z a t i o n by a p p r a i s a l te c h n iq u e s. P o s s ib ly th e re a s o n l i e s i n th e f a c t t h a t t h i s c h o ic e o f c a p i t a l i z a t i o n was n o t l i s t e d on th e q u e s t i o n n a i r e. P la n t A sse t D e le tio n s I n c e r t a i n s i t u a t i o n s, e x i s t i n g p l a n t a s s e t s sh o u ld be o m itte d from th e in v e s tm e n t c e n te r m a n a g e r's b a se c a l c u l a t i o n. An exam ple i s i d l e a s s e t s, w here th e u t i l i z a t i o n d e c is io n i s n o t s u b je c t to th e c o n tr o l o f th e segm ent m anager. However, i f th e segm ent m anager does c o n tr o l th e u t i l i z a t i o n d e c is io n, th e n i d l e a s s e t s sh o u ld be in c lu d e d 5 5 R a v e n s c ro ft, op, c i t., p. 101.

161 in h i s in v e s tm e n t b a s e, i f f o r no o th e r re a s o n th a n to 147 p ro v id e an i n c e n ti v e f o r u t i l i z a t i o n o r d i s p o s a l. Care m ust be e x e r c is e d i n t h i s c a s e, how ever, b e ca u se i t m ight en co u rag e th e segm ent m anager t o d is p o s e o f such a s s e t s m e re ly t o re d u c e h i s in v e s tm e n t b a s e. The i n c l u s i o n o f a s s e t s u t i l i z e d by c o rp o r a te h e a d q u a r t e r s and s h a re d f a c i l i t i e s i n th e in v e s tm e n t b ase can a ls o be q u e s tio n e d. I n th e l a t t e r c a s e, i f two o r more segm ents s h a re th e same f a c i l i t i e s and th e v a r io u s segm ent m an ag ers' r e s p o n s i b i l i t y and a u t h o r i t y i s n o t c l e a r l y d i v i s i b l e, th e n th e s e r e s o u r c e s sh o u ld n o t e n t e r an i n d i v i d u a l segm ent m a n a g e r's b a se d e te r m in a tio n. T h is c o n te n tio n i s c o n tr a r y to th e m a j o r it y c o r p o r a te re s p o n s e i n TABLE 20 where 54 p e r c e n t o f th e firm s in c lu d e sh a re d f a c i l i t i e s in a segm ent m a n a g e r's in v e s tm e n t b a s e. At t h i s p o in t th e r e i s no n e ed to re h a s h th e p ro b lem s in c u r r e d i n b a se a l l o c a t i o n s a s th e p ro b lem s e x p e rie n c e d p a r a l l e l th o se a lr e a d y d is c u s s e d in C h a p te r 4. FINALIZING THE SEGMENT MANAGER'S INVESTMENT BASE i THE ROLE OF LIABILITIES T here a p p e a rs to be c o n s id e r a b le d isa g re e m e n t, a s shown i n TABLE 25 (page ), a s to w h e th e r th e segm ent m anager sh o u ld be e v a lu a te d on th e s o u rc e s o f a s s e t s a s w e ll a s t h e i r u s a g e. T h is d if f e r e n c e o f o p in io n a ls o e x te n d s to th e l i t e r a t u r e. I n t h i s r e s p e c t, some a u th o r s c la im t h a t th e se g m en tal in v e s tm e n t b a se sh o u ld be n e t o f

162 TABLE 25 ANALYSIS OF SEGMENTAL INVESTMENT BASEi ROLE OF L IA B IL IT IE S DEDUCTION OF LIABILITIES QUESTIONNAIRE INQUIRY AND DEDUCTION RESPONSE Are any o f th e fo llo w in g ty p e o f l i a b i l i t i e s d ed u cted in f i n a l i z i n g a seg m en t's in v e stm e n t b ase? TOTAL FIRMS YES NO NOT APPLICABLE PERCENTAGE OF TOTAL TOTAL FIRMS PERCENTAGE OF TOTAL TOTAL FIRMS PERCENTAGE OF TOTAL C u rre n t i n t r a f i r m p a y a b le s # # 15 7# C u rre n t tr a d e p a y a b le s ^5# # 6 3# O th er c u r r e n t l i a b i l i t i e s # # 4 2# N o n -c u rre n t e x te r n a l d e b t. 4 l 19# # 6 3# TOTAL FIRMS 100# 215 SOURCEi C o rp o ra tio n s re sp o n d in g t o q u e s tio n n a ir e.

163 14-9 a l l c u r r e n t l i a b i l i t i e s. ^ O th e r w r i t e r s c a l l f o r a deduct i o n o f i n t e r e s t - f r e e l i a b i l i t i e s i n o rd e r to le a v e i n th e b a se t o t a l r e s o u r c e s p ro v id e d s p e c i f i c a l l y in th e e x p e c ta t i o n o f e a rn in g a m o n etary r e t u r n. 57 S t i l l o th e r s arg u e t h a t th e d e d u c tio n o f any l i a b i l i t y am ounts to a c o n fu sio n betw een a s s e t u sa g e and f in a n c in g decisionst he m a jo r ity o p in io n o f th e re s p o n d in g c o r p o r a tio n s seem s to a g re e w ith t h i s l a s t c o n te n tio n t h a t l i a b i l i t i e s sh o u ld n o t be deducte d a t a l l i n a r r i v i n g a t th e r e s o u r c e b a se t o t a l. I n e s s e n c e, th e s e n tim e n t im p lie d i s t h a t th e d e d u c tio n o f l i a b i l i t i e s d e s tr o y s th e e f f e c t i v e n e s s o f ROI and r e s i d u a l incom e a s p e rfo rm an c e m e a su re s. F u rth e rm o re, th e assum p t i o n i s t h a t a l l a s s e t s, r e g a r d l e s s o f s o u rc e, sh o u ld be u se d w ith e q u a l e f f e c t i v e n e s s i n th e p r o f i t e a rn in g p ro c e s s. T h e re fo re, i t would a p p e a r t h a t segm ent m anagers a re n o t to be co n ce rn e d w ith s o u rc e s o f fu n d s u se d to a c q u ire segm ent a s s e t s w h e th e r th e s e s o u rc e s c o n s i s t o f e q u ity c a p i t a l, l e a s i n g a g re e m e n ts, o r lo n g - a n d - s h o r t term b o rro w in g s. In t h i s stu d y, th e em phasis i s p la c e d on m a n a g e ria l re s p o n s i b i l i t y f o r a l l a s s e t s u n d e r a segm ent m a n a g e r's c o n tr o l. As such, th e m a jo r ity c o rp o r a te o p in io n r e g a r d in g th e r o l e o f l i a b i l i t i e s i s c o n g ru e n t w ith th e o v e r a l l c o n te n tio n o f -^Solom ons, op. c i t., p p ^* - ^ S h illin g la w, " D i v i s i o n a l i z a t i o n, D e c e n tr a liz a tio n and R e tu rn on In v e s tm e n t," op. c i t., p. 25* ^T h o m as C asson, "R eturn, on I n v e s tm e n t," F in a n c ia l E x e c u tiv e. 21 (S ep tem b er, 195^5» 5 l i.

164 150 t h i s s tu d y. SUMMARY The te c h n iq u e s p r e s e n t l y em ployed by c o r p o r a tio n s in d e r iv in g and v a lu in g th e segm ent manager* s in v e s tm e n t b a se te n d to co n fu se c o n t r o l l a b l e and n o n c o n tr o lla b le re s o u rc e com ponents. By so d o in g, a segm ent m a n a g e r's s u c c e s s in econom izing a c o n t r o l l a b l e r e s o u r c e may be more th a n o f f s e t by an in c r e a s e in a n o n c o n tr o lla b le e le m e n t. T h is e f f e c t n o t o n ly c a u se s f r u s t r a t i o n and b re e d s an en v iro n m en t f o r su b o p tim a l m o tiv a tio n, b u t i t a ls o d im in is h e s th e e f f e c tiv e n e s s o f ROI and r e s i d u a l incom e a s m a n a g e ria l p e r f o r mance m e a su re s. T h is d u a l p ro b lem o f a s s e t c o m p o sitio n and v a lu a tio n in d e te rm in in g an in v e s tm e n t c e n te r m a n a g e r's re s o u rc e b a se i s p ro b a b ly th e so u rc e o f g r e a t e s t c o n fu s io n and c o n tro v e rs y b o th i n p r a c t i c e and i n th e l i t e r a t u r e on in v e s tm e n t c e n t e r s. A c c o rd in g ly, th e n e x t c h a p te r w i l l recommend f e a s i b l e m ethods o f r e s o l v in g some o f th e d i f f i c u l t i e s p r e s e n te d in b o th th e c u r r e n t and p re c e d in g c h a p t e r s.

165 C h a p te r 6 SUMMARY AND CONCLUSIONS The o b je c tiv e o f t h i s r e s e a r c h was to co n d u ct an i n q u ir y i n t o th e m ethods u se d by i n d u s t r i a l c o rp o r a tio n s i n t h e i r e v a lu a tio n o f in v e s tm e n t c e n t e r m a n a g e ria l p e r f o r m ance, and a f t e r c o m p le tin g t h i s i n q u ir y, to recommend im provem ents i n th e p ro c e d u re s p r e s e n t l y u t i l i z e d. As such, th e d u a l h y p o th e s e s w hich form ed th e b a s i s o f t h i s stu d y w ere a s f o l lo w s» 1. The m easurem ent c r i t e r i a p r e s e n t l y u se d i n a s s e s s in g th e e f f e c t i v e n e s s o f in v e s tm e n t c e n te r m a n a g e ria l p e rfo rm an c e i s in f lu e n c e d to o s tr o n g l y by g e n e r a l l y a c c e p te d a c c o u n tin g p r i n c i p l e s to be an i n t e r n a l l y m e a n in g fu l e v a l u a ti o n, and 2. Too much r e l i a n c e on g e n e r a l l y a c c e p te d a c c o u n tin g p r i n c i p l e s c a u se s d i s t o r t i o n s i n th e e v a lu a tiv e p ro c e s s and may r e s u l t i n m is d ir e c te d m a n a g e ria l m o tiv a tio n w ith r e s p e c t to o p tim iz in g t o t a l company p e rfo rm a n c e. CONCLUSIONS The e v id e n c e a c c u m u la te d i n th e p re c e d in g c h a p te r s i s s u f f i c i e n t to a f f ir m th e g e n e r a l v a l i d i t y o f b o th o f th e a b o v e - s ta te d h y p o th e s e s. D e f in i t e p r o o f o f s u b s t a n t i a l r e l i a n c e on e x t e r n a l l y - o r i e n t e d a c c o u n tin g p r i n c i p l e s h as 151

166 b e en p ro v id e d a s w e ll a s i l l u s t r a t i o n s o f b o th m easurem ent b a se d i s t o r t i o n and s u b o p tim a l m o tiv a tio n. A summary o f e v id e n c e i n s u p p o rt o f th e above i s p ro v id e d i n TABLE 26 (p a g e s 153 and 15*0. I n a d d it i o n to th e p ro c e d u re s c r i t i c a l l y rev ie w ed i n t h i s t a b l e, c o rp o r a te i n s i s t e n c e on th e u n if o r m ity and c o n s i s t e n t a p p l i c a t i o n o f th e s e p ro c e d u re s among i t s i n t e r n a l segm ents i s lo o k e d upon u n fa v o ra b ly. One re a s o n i s th e a u t h o r i t a r i a n c o n n o ta tio n t h a t such a re q u ire m e n t im p lie s, w h ile a n o th e r more im p o rta n t re a s o n i s t h a t such a re q u ire m e n t f a i l s to re c o g n iz e th e u n iq u e n e s s and h e te ro g e n e o u s n a tu r e o f th e v a r io u s in v e s tm e n t c e n te r se g m en ts. W hile th e v a l i d i t y o f th e h y p o th e s e s h a s, in g e n e r a l, been a f f ir m e d, one a r e a o f d o u b t im p lie d i n th e second h y p o th e s is re m a in s. T h is u n r e s o lv e d a r e a p e r t a i n s to th e d e g re e o f c o r r e l a t i o n e x i s t i n g, i f any, betw een m easurem ent b a se d i s t o r t i o n and th e o c c u rre n c e o f su b o p tim a l m o tiv a t i o n a l a c t i o n s. On t h i s p o i n t, th e stu d y h a s n o t e s ta b lis h e d a s u f f i c i e n t fo u n d a tio n to p ro v e th e e x is te n c e o f such a c o r r e l a t i o n, though some d e g re e o f c a u s e - a n d - e f f e c t i s b e lie v e d t o e x i s t. I n t h i s s tu d y, th e o n ly r e c i p r o c a l r e l a t i o n s h i p t h a t h a s been a ff ir m e d p e r t a i n s t o th e d i s t o r t i o n and su b o p tim a l o p p o r t u n i t i e s t h a t can a r i s e a s a r e s u l t o f u s in g p ro c e d u re s i n a c c o rd a n c e w ith e x t e r n a l l y - o r i e n t e d m easurem ent p r i n c i p l e s. These o p p o r t u n it i e s a re o f te n ta k e n a d v a n ta g e o f due to th e em phasis p la c e d on in a p p ro p r i a t e p r o f i t g o a ls c o u p le d w ith th e b a s ic u n f a i r n e s s o f

167 TABLE 26 SUMMARY OP EVIDENCE TO SUPPORT RESEARCH CONCLUSION PROCEDURES USED BY CORPORATIONS Use o f b e fo re o r a f t e r t a x p r o f i t s as th e p r o f i t b a se i Use o f " f u l l " c o s tin g m ethodologyi Use o f L.I.F.O. b a se d in v e n to ry v a lu a tio n : S ig n if ic a n t u se o f in te rs e g m e n t t r a n s f e r p r i c e s : A llo c a tio n o f sh a re d a s s e t s and c e n t r a l f a c i l i t i e s : PERFORMANCE DISTORTION Im proper p r o f i t em phasis on lo n g -te rm p e rfo rm an c e. In c lu d e s e f f e c t o f noncont r o l l a b l e ite m s in p r o f i t b ase d e r iv a tio n. R e f le c ts m is le a d in g in v e n t o r y v a lu e and a llo w s s h o r t- te r m p r o f i t m anip u la tio n by v a ry in g endo f - p e r io d p u rc h a s e s. Weakens and d i s t o r t s p ro f i t a s a perform ance m easure because p r o f i t becomes dependent on th e t r a n s f e r p r i c e. In c lu d e s e f f e c t o f noncont r o l l a b l e a s s e t s i n th e in v e stm e n t b a s e. PROCEDURE EFFECTS CORPORATE SUBOPTIMIZATION D isco u rag es s h o rt- te r m e f f i c ie n c y because sa v in g s i n c o n tr o lla b le c o s ts may be more th a n o f f s e t by in c r e a s e s in u n r e la te d n o n c o n tr o lla b le c o s ts. A b so rp tio n c o s tin g elem ent o f f u l l p ro d u c t c o s tin g e n a b le s in c r e a s e s i n s h o rt-te rm p r o f i t by i n e f f i c i e n t in c r e a s e s in p ro d u c tio n n o n p ro p o rtio n a te ly o v er s a l e s. E ncourages i n e f f i c i e n t r e t e n t i o n o f low L.I.F.O. c o s t-v a lu e d in v e n to ry. C o st-b a se d t r a n s f e r p r i c e s d i s courage su p p ly in g segment c o s t e f f i c ie n c y m o tiv a tio n. A lso, p r o f i t s o f one segm ent may in c r e a s e to th e d e trim e n t o f th e c o rp o ra tio n a s a w hole. I f b ased on s a le s o r g ro ss p r o f i t, a m anager may r e s t r i c t s a l e s to av o id a m o re -th a n -p ro p o rtio n a l c o s t a l l o c a t i o n. 153

168 Em phasis on th e u se o f n e t hook v a lu a tio n and e x te r n a l m ethods o f d e p re c ia tio n! Use o f g ro s s c o s t b ase v a lu a tio n a s an a l t e r n a t i v e t o n e t book v a lu e : F a ilu r e to in c lu d e th e e f f e c t o f a l l le a s e d a s s e t s i n b a s e i Net book v a lu a tio n i n c r e a s es perform ance a s a s s e t s become l e s s e f f i c i e n t and a ls o f a i l s to r e p r e s e n t e i t h e r a s s e t c o s t o r p r e s e n t v a lu e i n b ase j e x te r n a l d e p r e c ia tio n m ethods o v e r s ta te p r o f i t as a s s e t s ag e, e s p e c i a l l y i f d e c lin in g b a la n c e m ethods a re u se d. Can r e s u l t i n double c o u n tin g i n th e re s o u rc e b a s e. U n d e rs ta te s in v e stm e n t b ase and o v e r s t a t e s p e rfo rm a n c e. D iscourages new in v e stm e n t and segment grow th and may en co u r age p rem atu re d is p o s a l o f p ro d u c tiv e re s o u rc e s in i d l e p e r io d s. Net book v a lu e a ls o f a i l s to m o tiv a te p r o f i t a b l e re in v e stm e n t o f fu n d s g e n e ra te d th ro u g h d e p r e c ia tio n. E ncourages th e d is p o s a l o f i d l e a s s e t s and c a u se s in c o n s is te n t perform ance r e s u l t s in re p la c e ment d e c is io n s. In th e l a t t e r c a se, re p la c e m e n ts below th e c o rp o ra te minimum r e t u r n r a t e may im prove a segm ent manager* s r e t u r n p e rfo rm an c e. Because le a s in g i s l e s s ex p en siv e th a n o u tr ig h t p u rc h a se o f an a s s e t, segm ent management w i l l le a s e a s o f te n a s p o s s ib le. T his a c tio n may be to th e lo n g term d e trim e n t o f th e c o rp o ra t i o n a s a w hole. SOURCEi C h ap ters 4 and 5 in t h i s s tu d y. I-*

169 155 th e r e s u l t i n g t o o l m ea su re s. RECOMMENDATIONS As a r e s u l t o f t h i s r e s e a r c h i n q u ir y, th e f o llo w in g im provem ents in m easurem ent p ro c e d u re a re recom m ended. The p u rp o se o f th e s e recom m endations i s to r e s o lv e m ost o f th e problem s c i t e d in t h i s stu d y a s w e ll a s to p ro v id e a f a i r and e f f e c t i v e b a se f o r m a n a g e ria l p e rfo rm an c e a s s e s s m e n t. I n t e r n a l M easurem ent System The i n t e r n a l m easurem ent sy stem sh o u ld c o n s id e r th e fo llo w in g o p e r a t i n g - r e s p o n s i b i l i t y fram ew ork i n se e k in g to e v a lu a te m a n a g e ria l segm entsi A u th o rity C o n t r o l l a b i l i t y R e s p o n s ib ility A c c o u n ta b ility T h is fram ework em p h asizes t h a t «1. A dequate d e c is io n a u t h o r i t y i s th e key to re s o u r c e c o n t r o l l a b i l i t y, 2. R e s p o n s ib ility e x i s t s o n ly f o r r e s o u r c e s o v er which th e segm ent m anager e x e r c i s e s s u b s t a n t i a l c o n tr o l, and 3. The segm ent m anager i s to be h e ld a c c o u n ta b le in term s o f p erfo rm an ce e f f e c t i v e n e s s f o r a l l e le m e n ts o v er which he e x e r c is e s d i v i s i b l e r e s p o n s i b i l i t y. W ith r e s p e c t to th e a re a o f p erfo rm an ce a c c o u n ta b il i ty,

170 156 th e e s ta b lis h m e n t o f i n t e r n a l m easurem ent s ta n d a rd s i s e s s e n t i a l, and th e fo llo w in g g u i d e l i n e s, th ro u g h n o t i n t e n ded to com prise an a l l - i n c l u s i v e l i s t, a r e recommended f o r c o n s i d e r a t i o n i R e le v a n c e. The c o n c e p t o f re le v a n c e sh o u ld p ro v id e th e c o rn e rs to n e i n c o n s tr u c tin g i n t e r n a l m easurem ent g u id e lin e s b e c a u se re le v a n c e im p lie s t h a t an im m ediate d i s t i n c t i o n be drawn betw een th e in fo rm a tio n n e e d s o f th e u s e r s in v o lv e d, w h e th er th e s e u s e r s a re i n t e r n a l o r e x t e r n a l. In a d d it i o n, th e re le v a n c e c o n c e p t em p h asizes th e a d a p ta tio n o f a c c o u n t in g p ro c e d u re s w ith in a segm ent b a se d on th e s e g m e n t's u n iq u e n e s s and h e te ro g e n e o u s n a tu r e, a s opposed to p ro c e d u r a l u se b e in g g o v ern ed by th e e x te r n a l s ta n d a r d s o f c o n s is te n c y and u n if o r m ity. O p e ra tio n a l In d e p e n d e n c e. S egm ental o p e ra tin g in d e pendence w i l l h e lp to a s s u r e a minimum o f seg m en tal p e r f o r mance in te rd e p e n d e n c e, and th u s, w i l l a id th e cau se o f a s s u r in g d i v i s i b l e r e s p o n s i b i l i t y among i n t e r n a l e n t i t i e s. G o - V a r ia b ility and C ongruency. C o - v a r i a b i l i t y r e q u i r e s t h a t th e incom e m easured f o r a segm ent c o rre sp o n d in d i r e c t io n to th e o v e r a l l change in th e s e g m e n t's c o n tr i b u ti o n to t o t a l company p r o f i t. Congruency e x te n d s t h i s g u id e lin e to in c lu d e th e p ro p e r c o o rd in a tio n o f seg m en tal and c o rp o ra te i n t e r e s t s in a l l r e s p e c t s. Both g u i d e l i n e s im ply th e u se o f u n b ia s e d m easurem ent p ro c e d u re s a s w e ll a s th e e s t a b l i s h ment o f c o o rd in a te d t a r g e t g o a ls among th e seg m en ts.

171 The above g u id e lin e c o n s id e r a tio n s em phasize t h a t th e e v a lu a tiv e n e ed s o f i n t e r n a l and e x te r n a l u s e r s d i f f e r, and t h i s d i f f e r e n c e can be a t t r i b u t e d to th e d e s i r e f o r i n t e r n a l p erfo rm an ce s e g m e n ta tio n. As su ch, th e s ta n d a r d s a d a p te d i n t e r n a l l y sh o u ld o b v io u s ly d i f f e r to some d egree from th o s e g u id e lin e s s a n c tio n e d by e x t e r n a l l y - o r i e n t e d a c c o u n tin g p r i n c i p l e s. Due to th e m u ltip le d im ension o f i n t e r n a l (a s opposed to e x te r n a l) in fo r m a tio n n e e d s, th e i n t e r n a l s ta n d a rd s m ust be lo o s e ly e s t a b l i s h e d and a llo w s u f f i c i e n t l a t i t u d e f o r p ro c e d u ra l d i f f e r e n t i a t i o n. The g u id e lin e s su g g e ste d f o r c o n s id e r a tio n i n th e above s e c tio n p o s s e s s th e c h a r a c t e r i s t i c o f v e r s a t i l i t y and a t th e same tim e, a id in th e m a x im iz a tio n o f i n t e g r a t e d seg m en tal c o n t r o l a v i t a l g o a l i n to d a y s com plex o r g a n iz a tio n s. Use o f ROI and R e s id u a l Income Due to th e p o t e n t i a l c o n f l i c t in p e rfo rm an c e r e s u l t s t h a t can emerge betw een r a t i o ( r e l a t i v e ) and d o l l a r ( a b s o lu te ) r e t u r n s, a d i s t i n c t i o n i n t o o l u t i l i z a t i o n i s e s s e n t i a l. In t h i s r e s p e c t, th e u se o f r e t u r n on i n v e s t ment i s m ost a p p r o p r ia te in s i t u a t i o n s where th e segm ent m anager e x e r c is e s c o n tr o l o v e r re v e n u e s, e x p en se s and a s s e t u t i l i z a t i o n o n ly. In e s s e n c e, he p o s s e s s e s l i t t l e c o n tr o l o v e r th e l e v e l o f segm ent in v e s tm e n t w hich im p lie s t h a t he i s n o t s i g n i f i c a n t l y in v o lv e d in re s o u r c e re p la c e m e n t, r e in v e s tm e n t, o r d is p o s a l d e c is io n s. Thus, i f th e l e v e l o f h i s in v e s tm e n t b a se i s r e l a t i v e l y f ix e d o v e r th e s h o r t ru n,

172 th e id e a o f " c o n t r o l la b l e in v e s tm e n t" i s m e a n in g le s s. In o th e rw o rd s, i f re s o u rc e c o m p o sitio n d e c is io n s l i e o u ts id e th e segm ent m a n a g e r's domain o f c o n tr o l, th e in v e s tm e n t b a se sh o u ld be d e fin e d a s " t o t a l r e s o u r c e s em ployed i n o p e ra tio n s " i n s t e a d o f th e " c o n t r o l la b l e r e s o u r c e s em ployed" d e f i n i t i o n p r e v io u s ly su g g e ste d i n C h a p te r 5«A d d itio n a lly, i n t h i s s i t u a t i o n, th e u se o f ROI w i l l n o t y i e l d c o n f l i c t i n g p e r form ance r e s u l t s w ith th e a l t e r n a t i v e m easure o f r e s i d u a l income b e c a u se in th e s h o r t- te r m tim e fram e, th e in v e stm e n t b a se i s o f a f ix e d m a g n itu d e. As such, th e m ax im iz a tio n o f ROI a ls o s im u lta n e o u s ly m axim izes a b s o lu te d o l l a r p r o f i t. A lthough th e s i t u a t i o n o u tlin e d above does n o t r e p r e s e n t th e d e c is io n a u t h o r i t y t h a t sh o u ld be p o s s e s s e d by a " r e a l" in v e s tm e n t c e n te r m anager, i t would a p p e a r t h a t some in d u s t r i a l c o r p o r a tio n s i n t e r p r e t th e e x te n t o f in v e s tm e n t c e n te r d e c is io n autonom y in e x a c tly t h i s w a y. j n o th e rw o rd s, th e in v e s tm e n t c e n te r r e s p o n s i b i l i t y co n ce p t i s som etim es m isused in s i t u a t i o n s d is g u is e d by p r o f i t c e n te r a u t h o r i t y. Based on th e fo re g o in g, th e n, th e u se o f r e s i d u a l income i s r e s e r v e d f o r segm ent m anagers who p o s s e s s th e d e c is io n d i s c r e t i o n In te n d e d by th e in v e stm e n t c e n te r r e s p o n s i b i l i t y c o n c e p t- - to e x e r c is e s u b s t a n t i a l c o n tr o l o v er th e s c a le o f o p e r a tio n s. In c lu d e d w ith in a segm ent m anager's a u t h o r i t y, th e n, i s th e a b i l i t y to in f lu e n c e re p la c e m e n t, 59An o p in io n d e riv e d from o b s e rv a tio n o f th e q u e s tio n n a i r e re s p o n s e s re g a rd in g r e s o u r c e s in c lu d e d in a segm ent m a n a g e r's in v e s tm e n t b a s e.

173 159 re in v e s tm e n t, and d is p o s a l o f r e s o u r c e s a s w e ll a s to c o n tr o l t h e i r u t i l i z a t i o n. In summary, th e above recommended d i s t i n c t i o n i n to o l u t i l i z a t i o n stem s from th e f a c t t h a t i f segm ent management can s i g n i f i c a n t l y in f lu e n c e th e s iz e and c o m p o sitio n o f th e segm ent in v e s tm e n t b a s e, th e n r e t u r n on in v e s tm e n t i s g r e a t l y weakened a s a m easure o f m a n a g e ria l p e rfo rm an c e e f f e c t i v e n e s s. P r o f i t Base D e riv a tio n In th e c a l c u l a t i o n o f se g m e n ta l p r o f i t f o r ROI and r e s i d u a l incom e, how f e a s i b l e i s th e c o n s t r u c t io n o f t h i s i n t e r n a l p r o f i t m easure o u t o f th e a lr e a d y e x i s t i n g e x te r n a l m easurem ent system? In o th e rw o rd s, c o u ld th e e x te r n a l m easurem ent o f p r o f i t sim p ly be re a r r a n g e d in o r d e r t o der i v e an i n t e r n a l p r o f i t b a se? P r o f i t d e r i v a t i o n would be e a sy i f t h i s co u ld be a c c o m p lish e d f a i r l y ; how ever, due to th e la c k o f e x te r n a l system em phasis on d i v i s i b i l i t y, c o n t r o l l a b i l i t y, and b e h a v io r a l c h a r a c t e r i s t i c s o f re v e n u e s and e x p e n se s, a sim p le re a rra n g e m e n t o f e x t e r n a l d a ta i s n o t an a p p r o p r ia te s o l u t io n to th e i n t e r n a l m easure o f p r o f i t. A recommended s o l u t io n, a lth o u g h n o t a p e r f e c t one, i s to im prove th e p r e s e n t d e r i v a t i o n and em phasize th e r o l e o f " c o n t r o l la b l e " p r o f i t in th e s h o r t r u n. As such FIGURE 9 (page 160) i l l u s t r a t e s th e s u g g e ste d m ethod o f d e riv in g t h i s c o n t r o l l a b l e p r o f i t m easure f o r ROI and r e s i d u a l income a p p l i c a t i o n s. E m phasis on a c o n t r o l l a b l e p r o f i t

174 160 RETURN ON RESIDUAL INVESTMENT INCOME N et S a le s... $ x,x x x $ x,x x x Less* C o n tr o lla b le v a r i a b l e c o s t o f goods s o l d... -x.x x x -x.x x x G ross M a rg in... $ x,x x x $ x,x x x L essi C o n tr o lla b le v a r i a b l e m ark et and a d m i n i s t r a t io n e x p e n se s.. -x.x x x -x.x x x C o n tr ib u tio n M argin $ x,x x x $ x,x x x L e ssi F ix ed e x p e n se s d i r e c t l y id e n t i f i a b l e w ith and c o n t r o l l a b l e by th e segm ent m anager in th e s h o r t - r u n p lu s d e p r e c ia tio n on c o n t r o l l a b l e in v e s tm e n t xxx - xxx P erfo rm an ce ( C o n tr o lla b le ) M argin f o r R e tu rn on In v e s tm e n t.... ^ L lxxx $ x, x x x L e s s i I n t e r e s t and c a p i t a l c h a rg e s on c o n t r o l l a b l e in v e s tm e n t b a s e *... - xxx P erfo rm an ce ( C o n tr o lla b le ) M argin cf R e s id u a l Incom e.... D if f e r e n t c h a rg in g r a t e s a r e a p p lie d to d i f f e r e n t ty p e s o f a s s e t s i n th e c a l c u l a t i o n o f r e s i d u a l incom e. FIGURE 9 RECOMMENDED BASIS FOR PROFIT DERIVATION xxx b a se n o t o n ly e li m in a te s th e p r a c t i c a l d i f f i c u l t y o f c o s t a l l o c a t i o n, b u t a ls o rem oves th e t h e o r e t i c a l o b je c tio n to th e id e a t h a t b u s in e s s segm ent m anagers a re in d e p e n d e n tly c a p a b le o f e a r n in g a p r o f i t o r s u s ta i n in g a l o s s. F u r th e r m ore, i f m u lt i - p e r i o d o r lo n g -te rm p r o f i t a n a l y s i s i s s u b s e q u e n tly d e s i r e d, th e above system i s e a s i l y a d a p ta b le. As su ch, t h i s lo n g -te rm c o n t r o l l a b l e p r o f i t can be d e fin e d a s c o n s i s t in g o f th e p e rfo rm an c e m argin c o n tr i b u ti o n s o f th e s h o r t e r p e r io d s p l u s any re v e n u e s and m inus any ex p en ses w hich a re a tta c h e d s p e c i f i c a l l y to and a re c o n t r o l l a b l e by th e segm ent m anager i n th e e v a lu a tio n p e r io d.

175 l 6 l The i n c l u s i o n o f d e p r e c i a ti o n i n th e p e rfo rm an c e m arg in b a se d e riv e d on th e p r e v io u s page r e q u i r e s e x p la n a tio n, a s d e p r e c i a ti o n i s n o t g e n e r a l l y c o n s id e re d to be a c o n tr o l l a b l e expense i n th e s h o r t r u n. The re a s o n f o r i t s i n c l u s io n i s to r e f l e c t th e u t i l i z a t i o n o f c o n t r o l l a b l e p l a n t r e s o u r c e s d u rin g th e e v a lu a tio n p e r io d. As su ch, th e m ethod o f d e p r e c i a ti o n s e l e c te d sh o u ld r e f l e c t th e e x p e c te d i n c r e a s in g l o s s i n a s s e t o p e r a t io n a l e f f i c i e n c y o v e r tim e. B ecause none o f th e e x t e r n a l l y - o r i e n t e d d e p r e c ia tio n m ethods a re d e sig n e d to m eet t h i s i n c r e a s in g c h arg e n e ed, th e u se o f an a n n u ity ap p ro ach to d e p r e c ia tio n i s recom m ended. I n e s s e n c e, a n n u ity d e p r e c ia tio n r e p r e s e n t s a compound i n t e r e s t ap p ro ach to d e p r e c ia tio n r e c o g n i ti o n. FIGURE 10 i l l u s t r a t e s th e a n n u ity co n ce p t by assum ing a c o n s ta n t e a r n in g s r a t e o f $ 300, an i n i t i a l a s s e t c o s t o f $ 1,000 and a r e t u r n on t h i s a s s e t o f 20 p e r c e n ti B.V. o f B.V. o f 20# D e p re c ia tio n B eginning E nding Y ear P r o f i t - :R etu rn = R ecovery R eso u rces = R eso u rces 0 $ 1,000 l $300 - $200 = $100 $ 1, = = = = = * * I f a s s e t i s d is p o s e d o f a t th e end o f y e a r 6, a l o s s o f $7 would be r e c o g n iz e d. FIGURE 10 ANNUITY METHOD DEPRECIATION

176 162 I f d e p r e c i a ti o n i s d e te rm in e d i n t h i s m anner, th e n even i f n e t book v a lu a ti o n i s u s e d i n th e in v e s tm e n t b a s e, th e o v e r a l l p ro b lem o f an i n c r e a s in g ROI o r r e s i d u a l incom e due to th e m ere p a s s a g e o f tim e i s c o r r e c t e d. I n summary, th e b a s i s recommended f o r p r o f i t d e r iv a t i o n w hich in c lu d e s d e p r e c i a ti o n on c o n t r o l l a b l e r e s o u r c e s b u t e x c lu d e s c o s t a l l o c a t i o n s and o th e r s h o r t- te r m noncont r o l l a b l e e x p e n se s sh o u ld p ro v id e i 1. A f a i r b a s i s on w hich to a s s e s s m a n a g e ria l p e r f o r mance e f f e c t i v e n e s s, and 2. An a p p r o p r ia te p r o f i t m a x im iz a tio n o b je c tiv e in o rd e r mesh se g m e n ta l and c o rp o ra te g o a l co n g ru en cy. In v e s tm e n t B ase D e te rm in a tio n The o b j e c t i v e s o f in v e s tm e n t b a se d e r i v a t i o n sh o u ld be to p ro v id e a " f a i r " fo u n d a tio n on w hich to a p p r a is e segm ent m a n a g e ria l p e rfo rm a n c e and t o m o tiv a te th e segm ent m anager i n th e d i r e c t i o n o f fo rm u la tin g d e c is io n s c o n g ru e n t w ith th e o p tim iz a tio n o f c o rp o ra te i n t e r e s t s. The a d v e rse e f f e c ts ( p r e v io u s ly d is c u s s e d i n C h a p te r 5) o f u t i l i z i n g a c c o u n tin g book v a lu e s in d e te rm in in g se g m en tal re s o u r c e v a lu a ti o n in th e in v e s tm e n t b a se in c lu d e i 1. D i s t o r t i o n and i n c o n s i s t e n t b e h a v io r o f ROI and r e s i d u a l incom e, 2. R e s t r a i n t o f new in v e s tm e n t and d isc o u rag e m e n t o f segm ent g row th, 3. Lack o f p ro p e r m o tiv a tio n to r e i n v e s t re c o v e re d

177 163 re s o u rc e fu n d s p r o f i t a b l y, 4. P o t e n t i a l d u p l ic a t i o n o f r e s o u r c e s in th e i n v e s t ment b a s e, and 5. D is p o s itio n o f p r o f i t a b l e a s s e t s p re m a tu re ly. I t would a p p e a r from th e fo re g o in g t h a t a c c o u n tin g book v a lu e s c r e a te c o n s id e r a b le p ro b lem s t h a t c o u ld be re s o lv e d to some e x te n t by u s in g an a l t e r n a t i v e form o f v a lu a tio n in th e b a s e. The recommended s o lu tio n to t h i s r e v is e d v a lu a tio n i s c u r r e n t c o s t. I t sh o u ld be n o te d t h a t c u r r e n t, a s opposed to e i t h e r p a s t o r f u t u r e c o s t, i s m ost r e l e v a n t b ecau se i t i s p r e s e n t, n o t p r e v io u s o r f o r e c a s te d, p erfo rm an ce e f f e c t i v e n e s s t h a t one i s a tte m p tin g to m easu re. F u rth e rm o re, th e v a lu a ti o n em phasis i s on c u r r e n t e n tr y d e te r m in a tio n s b e ca u se th e in v e s tm e n t b a se r e p r e s e n ts th e a g g re g a te o f c o n t r o l l a b l e " in p u t" r e s o u r c e s in b o th th e ROI and r e s i d u a l incom e c a l c u l a t i o n s. Thus, f o r p u rp o se s o f p e rfo rm an ce m easurem ent, i t i s th e c u r r e n t v a lu e o f r e s o u r c e s p u t in, r a t h e r th a n th e c u r r e n t v a lu e o f r e s o u r c e s t h a t can be rem oved, w hich i s r e l e v a n t. The f o llo w in g i s a b r i e f o u t li n e o f how th e above c u r r e n t c o s t a p p ro a ch can be a d a p te d to v a lu in g s p e c i f i c a s s e t s i n th e in v e s tm e n t b ase 1 C ash. Assuming cash flo w s a re s u b s t a n t i a l l y c o n t r o l l a b l e by th e segm ent m anager, th e fo llo w in g p ro c e d u re i s recom m ended1 "Normal" c a sh b a la n c e s (b a se d on a v e ra g e segm ent e x p e n d itu r e s d e riv e d o v e r a r e p r e s e n t a t i v e p e r io d

178 164 o f tim e) sh o u ld he "e x c lu d e d " from h a se c o n s id e ra tio n * how ever, " e x c e s s iv e " cash r e s e r v e s r e t a i n e d by th e segm ent m anager sh o u ld be " in c lu d e d " a t t h e i r m o n etary v a lu e e q u i v a le n t i n h i s b a s e. U nder t h i s a rra n g e m e n t, a segm ent m anager sh o u ld be m o tiv a te d to t r a n s f e r i d l e o r e x c e s s cash to h e a d q u a r te r s and r e t a i n o n ly t h a t p o r t i o n w hich he th in k s he can p r o f i t a b l y r e i n v e s t. F u rth e rm o re, t h i s p h ilo s o p h y e n c o u ra g e s r e s p o n s i b i l i t y f o r c ash e f f i c i e n c y i n th e i n d i v id u a l segm ents where i t s h o u ld be r a t h e r th a n a t c o rp o r a te h e a d q u a r te r s. The o n ly p r e r e q u i s i t e to i n i t i a t i n g a system o f t h i s ty p e i s t h a t c o rp o r a te h e a d q u a r te r s m ust m a in ta in a s e p a r a te cash a c c o u n t b a la n c e f o r each i n t e r n a l segm ent. R e c e iv a b le s. Assum ing t h a t c r e d i t and c o l l e c t i o n c o n tr o l a re w ith in th e segm ent m a n a g e r's a u t h o r i t y, r e c e i v a b le s sh o u ld be in c lu d e d i n h i s in v e s tm e n t b a se a t t h e i r g r o s s m o n etary v a lu e. F u rth e rm o re, i f th e p e r io d o f e v a lu a tio n i s s i g n i f i c a n t l y lo n g, a v e ra g e, n o t b e g in n in g o r e n d in g, r e c e i v a b le s sh o u ld be c o n s id e re d i n th e b a s e. One re a s o n f o r in c lu d in g a v e ra g e r e c e i v a b le s i s to m inim ize a su b o p tim a l s i t u a t i o n t h a t can o th e rw is e a r i s e when a l a s t m in u te e f f o r t, r e g a r d l e s s o f lo n g -te rm c o n seq u e n ce s, i s made to c o l l e c t r e c e i v a b le s i n o r d e r to re d u c e t h e i r i n c l u s i o n in th e b a s e. I n a d d it i o n, a v e ra g e b a la n c e s te n d to be more r e p r e s e n t a t i v e o f p e rfo rm an c e th ro u g h o u t a lo n g p e r io d th a n a r e e i t h e r b e g in n in g o r en d in g b a la n c e s. I n v e n t o r i e s. As i n th e c a se o f r e c e i v a b l e s, i f th e e v a lu a tio n p e r io d i s s i g n i f i c a n t, a v e ra g e, i n s t e a d o f

179 b e g in n in g o r e n d in g q u a n t i t i e s, sh o u ld be c o n s id e re d i n th e 165 b a s e. V a lu a tio n o f th e s e q u a n t i t i e s, how ever, depends on th e fo llo w in g c o n d itio n s i 1. I n v e n t o r i e s m a n u fa c tu re d w ith in a segm ent and n o t a v a i la b l e e x t e r n a l l y sh o u ld be in c lu d e d i n th e b a se a t u p- t o - d a t e s ta n d a rd c o s ts w hich, i f c o r r e c t l y e s t a b l i s h e d, sh o u ld a p p ro x im ate c u r r e n t r e p r o d u c tio n c o s t. 2. I f t h i s m a n u fa c tu re d in v e n to r y i s a v a i l a b l e e x t e r n a l l y o r i f in v e n to r y i s p u rc h a s e d e x t e r n a l l y r a t h e r th a n m a n u fa c tu re d, th e n c u r r e n t c o s t can be d i r e c t l y o b ta in e d by u s in g e x te r n a l re p la c e m e n t c o s t. 3. For i n v e n t o r ie s a c q u ir e d by i n t e r n a l t r a n s f e r s from o th e r segm ents, th e t r a n s f e r p r i c e u se d depends on w h e th er e x te r n a l m ark et s o u rc e s e x i s t. I n th e s i t u a t i o n where e x te r n a l m a rk e ts e x i s t, th e m ost a p p r o p r i a te t r a n s f e r p r i c e seems to be th e e x te r n a l p r i c e l e s s a n e g o ti a t e d d is c o u n t f o r expense s a v in g s due t o th e i n t e r n a l n a tu r e o f th e s a l e. I n th e b u y in g s e g m e n t's in v e n to r y, t h i s p r i c e sh o u ld come v e ry c lo s e to a p p ro x im a tin g c u r r e n t re p la c e m e n t c o s t; o th e rw is e, th e segm ent m anager would p u rc h a s e from an e x te r n a l s o u rc e. T h is p ro c e d u re a ls o a llo w s th e s e l l i n g segm ent m anager to show a re a s o n a b le p r o f i t i n h i s p r o f i t b a s e. In th e above s i t u a t i o n, t r a n s f e r p r i c e s a re c o n t r o l le d by th e segm ents in v o lv e d in th e t r a n s f e r w ith th e e x te r n a l m ark et p r i c e b e in g u se d a s an i n i t i a l g u id e. In c a s e s where e x te r n a l m a rk e ts do n o t e x i s t f o r goods t r a n s f e r r e d i n t e r n a l l y, a problem in r e s o u rc e b a se v a lu a ti o n a s

180 166 w e ll a s p r o f i t d e te r m in a tio n a r i s e s. Where t r a n s a c t i o n s o f t h i s ty p e a re s i g n i f i c a n t, th e b e s t s o l u t io n i s to r e d e f in e se g m en tal b o u n d a rie s by m erging th e two segm ents; how ever, i n c a s e s where one segm ent s u p p lie s in v e n to r y to a num ber o f o th e r segm ents, th e above s o l u t io n w i l l n o t s u f f i c e. As an a l t e r n a t i v e, th e s u p p ly in g segm ent co u ld be d e s ig n a te d a s a s e r v ic e c e n te r r a t h e r th a n a s an in v e s tm e n t c e n t e r. As such, t h i s s e r v ic e segm ent would have th e s o le r e s p o n s i b i l i t y o f s e r v in g o th e r seg m en ts' n e e d s, b u t would n o t have th e r e s p o n s i b i l i t y o f h a v in g to e a rn a p r o f i t on th e s e i n te r n a l t r a n s f e r s. The a s s o c i a t e d p r i c e o f th e s e t r a n s f e r s sh o u ld be u p - t o - d a t e s ta n d a rd c o s t s. Thus, f o r i n t e r n a l t r a n s f e r s f o r w hich no e x te r n a l m a rk e ts e x i s t, th e p r i c e i s d e te rm in e d c e n t r a l l y and, c o n s e q u e n tly, i s n o t w ith in th e segm ent m a n a g e r's domain o f c o n t r o l. I n a d d itio n, th e f a c t t h a t th e s u p p ly in g segm ent does n o t r e c o v e r a l l o f i t s a c t u a l p r o d u c tio n c o s ts and e a rn a p r o f i t i s n o t p a r t i c u l a r l y im p o rta n t i f i t s p erfo rm an ce c l a s s i f i c a t i o n i s no lo n g e r w ith in th e p r o f i t o r in v e s tm e n t c e n te r r e s p o n s i b i l i t y fram ew ork. The im p o rta n t c o n s id e r a tio n in t h i s s i t u a t i o n i s t h a t th e b u y in g segm ent i s n o t fo rc e d to a b so rb any c o s t i n e f f i c i e n c i e s i n th e s u p p ly in g s e g m e n t's t r a n s f e r p r i c e. In summary, th e o v e r a l l recom m endation f o r in v e n to r y v a lu a tio n o f ite m s in c lu d e d in th e b a se em phasizes th e u se o f e i t h e r c u r r e n t re p r o d u c tio n o r re p la c e m e n t c o s t s ta n d a rd s. By u s in g an u p - t o - d a t e s ta n d a r d c o s t and rem oving p r i c e

181 16? v a r ia n c e s from th e segm ent m anager*s p r o f i t b a s e, th e e f f e c t i s to p ro v id e a m e a n in g fu l p e rfo rm an c e in d e x, w hich m easures se g m en tal com m ittm ent o f c o rp o r a te fu n d s to in v e n to r y in v e s tm e n t. At th e same tim e t h i s p ro d u c e s a p r o f i t b a se t h a t i s f r e e from f l u c t u a t i o n s i n th e p r i c e s a c t u a l l y p a id f o r m a n u fa c tu rin g r e s o u r c e s, s in c e t h i s p r i c e elem en t i s n o t g e n e r a l l y c o n t r o l l a b l e by th e segm ent m anager. P la n t a s s e t s. Only p l a n t a s s e t s u n d e r th e c o n tr o l o f a s in g le segm ent sh o u ld be in c lu d e d in th e segm ent manag e r 's in v e s tm e n t b a s e, r e g a r d l e s s o f w h e th e r th e s e a s s e t s a re p u rc h a se d o r le a s e d by th e segm ent. Thus, p l a n t a s s e t s u se d o n ly by c o rp o ra te h e a d q u a rte r s sh o u ld n o t be a l l o c a t e d to th e segm ent m a n a g e r's b a s e. As f o r p l a n t a s s e t s u se d by m u ltip le firm seg m en ts, no c o s t a l l o c a t i o n sh o u ld be made. I n s te a d assum ing th e segm ent m anager c o n tr o l s th e u t i l i z a t i o n r a t e o f s h a re d f a c i l i t i e s, a s opposed to fo rc e d u t i l i z a t i o n, th e m ost f e a s i b l e s o l u t io n i s to c h arg e a re a s o n a b le r e n t a l fe e f o r th e e x te n t o f s e r v i c e s p ro v id e d to each segm ent and in c lu d e t h i s r e n t a l fe e i n th e segm ent m a n a g e r's p r o f i t d e r i v a ti o n. Once c o n t r o l l a b l e p l a n t a s s e t c o m p o sitio n h a s been d e te rm in e d, th e q u e s tio n o f i t s v a lu a ti o n a r i s e s. H ere a num ber o f p o t e n t i a l v a lu e s emerge f o r a d e p r e c ia b le a s s e t b e ca u se th e a s s e t h a s one v a lu e when i t i s a c q u ir e d, a second on th e b o oks, a t h i r d i f re p la c e m e n t i s c o n te m p la te d, a f o u r th i f re p la c e m e n t c o s t i s re d u c e d by th e u se w hich h a s been made o f th e a s s e t, and a f i f t h v a lu e i f th e a s s e t

182 i s s o ld o r o th e rw is e d isp o se d o f. I n t h i s r e s p e c t, th e p erfo rm an ce e f f e c t i v e n e s s r e s u l t s w i l l v a ry d e p en d in g on th e v a lu e u se d and o b je c tio n s can be r a i s e d to th e u se o f any one o f th e s e v a lu e s. D e sp ite th e p rim a ry o b j e c ti o n o f s u b j e c t i v i t y t h a t i s o f te n c i t e d, d e p re c ia b le a s s e t s u n d e r th e segm ent m a n a g e r's c o n tr o l sh o u ld be in c lu d e d in h i s b ase a t t h e i r c u r r e n t o p e ra tin g v a lu e. T his v a lu e i s e q u a l to c u r r e n t c o s t l e s s d e p r e c i a ti o n. The m ethod o f a r r i v i n g a t t h i s a sse ssm e n t o f c u r r e n t c o s t v a lu e may be by d i r e c t re p la c e m e n t c o s t o f th e same o r com parable f a c i l i t i e s, by m ethods o f a p p r a i s a l, o r by e s tim a te s o f c u r r e n t c o s t r e p r o d u c tio n o r f a c i l i t y d u p l i c a t i o n. The n a tu r e o f th e m ethods a d o p te d depends on th e c o m p o sitio n o f p l a n t a s s e t s in th e b a se m ea su re. I n th e i n c l u s i o n o f n o n d e p re c ia b le p l a n t a s s e t s o r le a s e d a s s e t s, v a lu a ti o n i s p ro b a b ly b e s t o b ta in e d by u se o f a p p r a i s a l te c h n iq u e s ; how ever, in th e c ase o f le a s e d a s s e t s, th e c a p i t a l i z e d v a lu e o f th e l e a s i n g paym ents w i l l a ls o s u f f i c e i f th e e s tim a te d l i f e o f th e le a s e d a s s e t c o rre sp o n d s t o th e le n g th o f th e l e a s i n g com m ittm ent. R e s id u a l Income P erfo rm an ce In d ex I n view o f th e fo re g o in g recom m endations, th e o n ly re m a in in g d e t e r r e n t to th e u se o f th e r e s i d u a l incom e m easure in e v a lu a tin g in v e s tm e n t c e n te r m a n a g e ria l p e r f o r mance i s th e la c k o f in te r s e g m e n ta l c o m p a r a b ility in h e r e n t in a b s o lu te f i g u r e s. In o rd e r to m inim ize t h i s t o o l

183 w eakness, th e u s e o f a p e rfo rm an c e in d e x com parison b a s i s i s recom m ended. The in d e x u s e d sh o u ld r e l a t e a c t u a l r e s i 169 d u a l incom e p erfo rm an ce to a p re d e te rm in e d g o a l ra n g e. The minimum and maximum p a ra m e te rs o f t h i s ra n g e sh o u ld be b a sed on th e segm ent m anager*s o p e r a tin g en v iro n m en t e x p e c ta tio n s ; th u s, th e ra n g e e s t a b l i s h e d w i l l p ro b a b ly d i f f e r f o r each segm ent m anager. As su ch, th e fo llo w in g 2 v e r s io n s o f a p erfo rm an ce in d e x fo rm u la can be d e riv e d : RI - RI R Iq - RI_ PI = R It - RI o r PI = RIt - RI t m t a w here: RI = A c tu a l r e s i d u a l income a RIm = Minimum e x p e c te d r e s i d u a l incom e RI^ - D e sire d r e s i d u a l incom e t a r g e t g o a l The d i f f e r e n c e i n th e above two fo rm u la s i s one o f f l e x i b i l i t y. The f i r s t fo rm u la i s a p p lic a b le r e g a r d l e s s o f where a segm ent m a n a g e r's p erfo rm an ce l i e s w ith r e s p e c t to th e p r e s c r ib e d p a ra m e te r ra n g e w h ile u se o f th e second fo rm u la i s l i m i t e d to th o s e segm ent m anagers whose p e r f o r mance f a l l s w ith in t h i s ra n g e. THE NEED FOR ADDITIONAL RESEARCH The n eed f o r f u r t h e r r e s e a r c h e x te n d s to th e fo llo w in g th r e e b a s i c a r e a s : 1. There i s a need to e s t a b l i s h d e f i n i t e s ta n d a rd s f o r i n t e r n a l m easu res b e c a u se m easurem ent r u l e s a re subo r d in a te to m easurem ent s ta n d a r d s. U n til th e l a t t e r

184 170 i s e s t a b l i s h e d, th e v a l i d i t y o f th e p ro c e d u re s recommended in t h i s s tu d y i s l e f t i n a vacuum and c a n n o t be t e s t e d. 2, Some form o f c o r r e l a t i o n stu d y sh o u ld be u n d e r ta k e n i n o rd e r to d e te rm in e th e d eg ree o f r e l a t i o n s h i p betw een m easurem ent d i s t o r t i o n s and m o tiv a tio n a l re s p o n s e. In o th e rw o rd s, f u r t h e r a n a l y s i s on th e b e h a v io r a l im p lic a t i o n s o f p erfo rm an ce m easu res i s e s s e n t i a l. 3. An a n a l y s i s o f th e u n d e rg ra d u a te a c c o u n tin g c u r- ric u lu m s sh o u ld be i n i t i a t e d i n o rd e r t o a s c e r t a i n i f th e y a re p r e s e n t l y p r o v id in g th e a c c o u n tin g m ajo r w ith a w e llrounded ex p o su re to a l l a s p e c ts o f i n d u s t r i a l a c c o u n tin g p r a c t i c e. In t h i s p r e s e n t stu d y, i t i s s tr o n g l y s u s p e c te d t h a t to o much i n t e r n a l a c c o u n tin g e x p o su re i s g iv e n to p ro d u c t c o s t d e te rm in a tio n w hich r e s u l t s in th e s tu d e n t b e in g g iv e n a l i m i t e d ex p o su re to r e s p o n s i b i l i t y a c c o u n tin g. More s p e c i f i c a l l y, e i t h e r th e r e i s some d e f ic ie n c y in th e a c c o u n tin g e d u c a tio n o f o u r c o rp o ra te c o n t r o l l e r s o r th e s e i n d i v i d u a l s sim p ly la c k th e a b i l i t y to a d a p t t h e i r th o u g h t p r o c e s s e s from th e e x te r n a l to th e i n t e r n a l e n v iro n m e n t. The a ssu m p tio n made h e re i s t h a t c o rp o ra te c o n t r o l l e r s in f lu e n c e to some d eg ree th e p erfo rm an ce m easu res and p r o c e d u re s u se d in th e e v a lu a tio n o f i n t e r n a l m a n a g e ria l se g m en ts. As shown in t h i s stu d y, f a r to o much em p h asis i s p la c e d on th e u s e o f e x t e r n a l l y - o r i e n t e d m easurem ent p r o c e d u re s in a s i t u a t i o n where th e y a re n o t a p p li c a b l e.

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