QUESTION 03- BENSON FOODS (BENSON)
Company background and structure
Benson Foods (Benson) is a family-owned business which has grown strongly over its 100-year history. The objective of the business is to maximise the family's wealth through their shareholdings. Benson has three divisions. It manufactures a variety of foods in two of the divisions: Benson Baby Foods (Baby) and Benson Chocolate Foods (Chocolate). Each of these divisions knows its own market and sets prices accordingly. The third division (R&D) researches new products on the instructions of the other divisions and is considered to be vital to the survival and growth of Benson. The board of Benson has been considering the impact of using a divisional structure and has come to you as a performance management consultant to ask for your advice.
Divisional performance measures
There is disagreement at board level about the correct choice of divisional performance measure to be used in the two manufacturing divisions. Currently, the business uses EVATM but two directors have been questioning its value, complaining that it is complicated to understand. These directors have been promoting the use of either residual income (RI) or return on investment (ROI) as alternatives. The board wants to use the same measure for each division. As well as qualitatively evaluating these different measures, the board needs an assessment of the impact of a change in performance measure on their perception of these divisions' performance. Therefore, as an example, they require you to calculate and discuss the use of ROI and RI at Baby Division, given the data in Appendix 1.
Divisional control and management style
The Chief Executive Officer (CEO) of Benson has engaged a business analyst to perform a study of the portfolio of manufacturing businesses which make up Benson. This has been completed in Appendix 2. The CEO wants your comments (based on the categorisation given in Appendix 2) on how this work will impact on the performance management of the divisions. Specifically, the CEO has asked for your recommendations on how to control each division; that is, whether each division should be treated as a cost/profit/investment centre and also the appropriate management style to use for handling staff in each division. The CEO commented to you:
'I have heard of different approaches to the use of budget information in assessing performance: budget-constrained, profit-conscious and also a non-accounting style. I need to know how these approaches might apply to each division given your other comments.'
Managers' concerns
All of this work has been partly prompted by complaints from the divisional managers. The Chocolate divisional managers complain that they had to wait for a year to get approval to upgrade their main production line. This production line upgrade has reduced wastage and boosted Chocolate's profit margin by 10 percentage points. The Baby Division has been very successful in using the ideas of the Research and Development (R&D) Division, although Baby's managers do complain about the recharging of R&D costs to their division. Head office managers are worried about Chocolate as it has seemed to be drifting recently with a lack of strategic direction. Chocolate's managers are considered to be good but possibly not sufficiently focused on what benefits Benson as a whole.
Required
a. Assess the use of EVATM as a divisional performance measure for the manufacturing divisions at Benson.
(8 marks)
b. Using Appendix 1, calculate the ROI and RI for Baby and assess the impact of the assumptions made when calculating these metrics on the evaluation of the performance of this division and its management.
(7 marks)
c. Provide justified recommendations for each division's control and management style as requested by the CEO.
(10 marks)
(Total = 25 marks)
QUESTION 03- BENSON FOODS (BENSON)
a.
EVA™ as a divisional performance measure
Advantages
Maximising wealth – Benson's overall objective is to maximise the family's wealth through their shareholding – in effect, to maximise shareholder wealth.
One of the main benefits of EVATM as a performance measure (rather than profit-based measures such as ROI) is that it is a value-based approach, and therefore it will be aligned to the overall objective of maximising shareholder wealth.
Goal congruence – Moreover, using EVATM as a divisional measure will help to ensure that decisions taken at divisional level support the best interests of Benson as a whole, rather than just the individual division.
The other advantages of EVATM are:
- It gives an absolute measure of performance, and so shows the overall contribution the divisions make to the company.
- The basic test of performance is simple. If a division has a positive EVATM, then it is generating a return above that required by the providers of finance. (ROI requires a target level to be set, usually based on benchmarking to the industry sector.)
- The adjustments required when calculating net operating profit after tax mean that it is closer to cash flows than traditional accounting profits are, and also mean that EVATM is less subject to choices in accounting policies.
- EVATM encourages investment in the future (for example, in advertising and development) by adding back these costs to profit in the performance period and treating them like capital expenditure. This will reduce the temptation for dysfunctional, short-termist decision making, which could otherwise be a problem where the capital employed figure from the financial statements is used in ROI and RI. This is likely to be particularly appropriate at Benson where R&D is significant.
Disadvantages
However, EVATM does also have some disadvantages. Some of these are also disadvantages of ROI and RI, and some are specific to EVATM.
All three measures are dependent on historical data and so have limited use in forecasting future performance.
The directors' complaint that EVATM is complicated to understand appears reasonable, because of the number of adjustments which need to be made to the information from Benson's financial statements. By contrast, ROI and RI are derived from headline information in the financial statements which would be more familiar to the board. A related issue here would be the time and cost involved for Benson's management accountant in calculating the division's EVATM.
EVATM (like RI) uses a charge for the capital employed in the division. EVATM uses the weighted average cost of capital (WACC) for the company as a whole, which may not reflect the risks of the manufacturing divisions. Also, as an unlisted business, WACC may be difficult to estimate. By contrast, RI uses a notional cost of capital based on the risk of the divisions – although this will also be subject to an element of judgement and estimate.
Unlike ROI (which gives a percentage measure, rather than an absolute measure) EVATM will not help to assess relative divisional managerial performance at Benson if the divisions are of different sizes.
(8 Marks)
b.
ROI and RI
A key consideration when calculating either ROI or RI for Baby is what profit figure to use for the calculations.
The data in Appendix 1 suggests three potential profit figures, which could be used for assessing the performance of Baby as a division, and its manager:
Controllable profit – The only costs included in controllable profit are those under the direct control of the Divisional Manager (i.e., the divisional operating costs of $121m).
R&D costs recharged – Although the Divisional Manager cannot influence the costs of the R&D Division, Baby's divisional revenue includes the profit which results from new products and ideas generated by the R&D Division. Therefore, in order to match costs with revenues more fairly, a proportion of the R&D Division's costs should be included in Baby's profit figure.
Divisional profit – The division's performance (as distinct from the manager's performance) should take account of all relevant costs, including Baby's share of the head office management fees. As such the divisional profit ($60m) would be an appropriate figure to use in this respect.
Performance analysis
Regardless of which profit figure is chosen, Baby seems to be performing relatively well. Baby's EVATM is positive ($35m) and its RI is also positive.
In terms of ROI, the return based on divisional profit (14.2%) is lower than the ROI for similar entities (20%), but the return based on controllable profit, or profit after R&D, is higher than the benchmark figure. However, we do not know which profit figures were used in the benchmark figure, which means we cannot tell whether Baby's ROI figure is above or below the average achieved by similar entities.
|
Controllable profit |
Profit after R&D |
Divisional profit |
ROI |
|
|
|
Profit ($m) |
99 |
88 |
60 |
Capital employed ($m) |
424 |
424 |
424 |
ROI |
23.3% |
20.8% |
14.2% |
RI |
|
|
|
Profit ($m) |
99 |
88 |
60 |
Cost of capital ($m) (424 × 11%) |
46.6 |
46.6 |
46.6 |
RI ($m) |
52.4 |
41.4 |
13.4 |
(7 Marks)
c.
Management styles for the divisions
Baby Division
Responsibility centre – Baby's position as the star in Benson's portfolio, coupled with the fact it is developing and introducing new products, means that the division's focus should be on growth rather than cost control.
As such, it might seem appropriate for Baby to be treated as an investment centre, giving its managers autonomy to develop their business as they see fit.
However, it is not clear whether the divisional managers have the authority to make capital investment decisions or whether these are taken by head office. (Chocolate had to get approval from head office to upgrade its production line.)
If the authority for investment decisions remains with head office, then Baby should be treated as a profit centre, and managed according to its ability to generate profit.
Management style – A profit-conscious style focuses on longer-term performance and objectives (such as growth) whereas a budget-constrained style focuses on short-term performance and cost control.
Therefore, given the nature of Baby's market – and the market's rapid growth – the profit-conscious style would seem more appropriate for Baby.
However, elements of a non-accounting style (such as new product development) may also be appropriate. Given the costs associated with new products and rapid growth (such as the publicity campaign Baby ran to support its new product launch), we recommend that a non-accounting style is applied initially.
However, once the market sector begins to mature, then given Baby's strong market share its focus should shift to optimising its profits – at which point, a profit-conscious management style should be adopted.
Chocolate
Division Responsibility centre – As the Chocolate Division is the cash cow in the portfolio, Benson needs it to generate the profits and cash necessary to support Baby's growth.
However, as a cash cow, and operating in a market with limited growth opportunities, Chocolate is unlikely to receive much investment. As such, it would seem appropriate to treat Chocolate as a profit centre.
Nonetheless, it appears that Chocolate does still makes some capital expenditure (for example, the upgrade to its main production line). As such, it could be appropriate to treat Chocolate as an investment centre, so that its managers have the autonomy to take these decisions, rather than having to wait for head office to approve them.
Management style – Because it is operating in a mature market with limited growth opportunities, cost control is likely to be crucial in maintaining Chocolate's profitability. As such, a budget-constrained style will be the most appropriate management style for Chocolate.
R&D Division
Responsibility centre – The R&D Division does not generate any revenue in its own right, and therefore should be treated as a cost centre.
Nonetheless, it is important that the contribution the division makes to the group (through the overall profit generated by the products it develops) is not overlooked. The complaints which Baby's managers make about the recharge suggests they are only thinking about the costs rather than the revenue which the new products have generated for them.
As such, whilst Benson should continue to treat the R&D Division as a cost centre for control purposes, it would also be useful to monitor the profit generated by each new product over its life cycle, to demonstrate the division's value to the group as a whole.
Management style – As the R&D Division is a cost centre, it might seem appropriate to apply a budget-constrained management style.
However, it is important that potentially profitable developments are not rejected simply to keep the division's costs within a fixed budget – and there is a danger this could be the case under a budget-constrained management style.
Therefore, elements of a non-accounting style might also be appropriate – with a focus on the number of new product ideas being generated, and the market reaction to new products being developed.
As such, it may be necessary to adopt a management style which combines some elements of the budget-constrained style with others from the non-accounting style.
(10 Marks)