Florence Industries, Inc. is a company which provides three entirely different types of products and services through three divisions of the company: consumer products division, industrial products division and professional services. Each division is treated as an entirely different company and the performance evaluation criteria is return on assets in recent years after major shift. Although, the divisions used to be treated as profit centres, this decision meant they are treated more as investment centres. The Company in 2008 & 2009:
From the income statement for 2008 and 2009, it is noticed that there is an increase in revenue by 4% and 11% increase in net profit in 2009. From balance sheet for 2008 and 2009 it is noticed that Florence has issued shared and borrowed long term loan in order to invest in project required high asset cost as the company asset has increased by $ 50,460,000 during 2009. The Company has also declared a dividend to equity of $ 12,570,000 during 2009 and keep $ $11,736,000 to meet future expansion and expense of business Issues and Analysis:
Rejecting Proposals Just Based On Gross Margin Requirement: CFO Ben Johnson has recently rejected the new product proposal of product development manager of consumer products division Calvin Marone as its estimated return of 13.67%(exhibit 1) per year was less than the 15% minimum gross return % requirement any new investment proposal should generate in order to get approve. The company’s 2007 gross return was 9.3 % and Ben estimated that it should go up easily to 12% and set target for each division to bring new product proposal of more than 15% gross return generating capabilities. Then again, gross return of Company in 2009 after rejecting the Marone’s proposal was 9.4%. Suppose if Marone’s proposal would have been accepted, then the Company 2009 gross return would have been approximately 9.6% (Exhibit 2) which would have been even higher than 2008 gross return of 9.5%. So, rejecting proposals that would have actually been beneficial just based on gross margin estimations seems redundant. Return on Investment Comparatively Low In Terms of Free Cash Flow: As per the balance sheet of Florence, it is noticed that there has been an increase in cash balance of $ 390,000 during the year 2009 as compared to 2008 balance. During 2009, the Company has generated cash of $ 42,756,000 from operating activities and $ 13,950,000 from finance activities.
Further the Company has used cash of $ 56,316,000(Exhibit 3) in investing activities. Company has used its majority of cash flow generated from operational and financing activities in investing activities. However in case of Florence, the free cash flow is less than the amount of investment made by the company in 2009 which indicate that the company is highly dependent on third party finance for expansion. However, the company has taken initiatives to counter this. They have broken down divisions into investment centres as compared to cost centres which will help enhance the performance of the divisions and influence them to get more out of investments made. By converting the divisions in investment units, it become the overall responsibility of division managers to generate the profit to the company not only on the basis of revenue and expense but also on the basis of total asset employed in order to run the division. Same Performance Evaluation Standard for Each Division: There are some negatives that came out of the Investment Center approach. First, it may not be appropriate to use one Gross return performance standard for all divisions of Florence, considering differences in type of service provided, products, operations, risks, and differences in measurement because of asset age.
These divisions cannot be compared with the same yardstick. For example, Professional services division does not use much asset so it will be inappropriate to measure its performance on the basis of gross return % (exhibit 4). Also, as division manager of Industrial Products division tried to explain, Consumer Products Division had a lot of old machines in their assets meaning those depreciated assets, whatever return they come up with, are making things look better in terms of return on assets than they are in reality. Moreover, including allocated corporate asset in the computation of gross return figure means that division and division managers are held accountable for costs and assets over which they don’t have any control at all. Recommendations:
Have Other Evaluation Criteria Along with Investment Center Approach: The decision to treat divisions as investment center has its benefits. Benefits of this approach include improvement in operational decision making, reduction in cost of corporate administration, increased motivation at division level, and freeing corporate management up for more effective utilization. However, there are some pitfalls as well. Just having return on assets as decision criteria isn’t enough and they should take other criteria into account. Criteria like Economic Value Added which takes into account costs of financing the capital or even simple Net Profit which judges the division’s profitability as a whole. And, to counter the problem of having too many old machines in the consumer products division compare to other divisions, the company could take out the depreciation and compare to see how it affects ROA as a whole when taken in to account and when not.
That should give the company a clearer picture. Developing a Balanced Scorecard: Developing a balance scorecard should go some way to make sure performance evaluation is fair and is illustrative of actual performance as it takes into account different measures for different functions usually. In this case, Florence would of course has to make it about the divisions rather than functions of business. In the suggested balanced scorecard below (Figure-1) we can see a bit modified targets and measures for different divisions as their goals are slightly different. Figure-1
For both consumer products and industrial products divisions, returns based on both net profit and ROA are important and give a fairer comparison. Customer satisfaction (in Industrial products division’s case it’s more the satisfaction based on compliance with specific designs is another evaluation criteria for both and the target for both should be bettering last year’s performance in each measures. For the professional services division, the growth has been rapid in recent years and retaining that growth will be important. Another important measure is corporate social responsibility i.e. environmental impact studies the division performs which not only is required by the law but also helps build reputation for the company and is part of CSR activities. So, it’s important to keep that into context. Develop evaluation criteria for new projects: Florence Industries Inc. needs to change evaluation criteria for new projects as it is noticed they’re rejected a project that would have been beneficial for them every which way just because it didn’t fulfil ROA requirement. Along with ROA, CFO Ben could also analyse the below mentioned points before accepting or rejecting any new project: 1)Project payback period
2)Project NPV (Net present value)
3)Project IRR (Internal rate of return)
Florence’s sales growth has been phenomenal for a new company and now it’s time to make some major managerial decisions that will shape the future. And, they have started doing so by transforming the divisions into investment centers from profit centers. While it is a good way to go, creating a balance is necessity and having a more comprehensive knowledge about how every division is doing based on more than one evaluation criteria will be important. Each division is run in their own way and the dissimilarities are far greater to just keep evaluating them based on the investment approach. Also, they can’t keep rejecting projects based on one simple requirement as it hinders the growth of the company. That’s why we suggest Florence Industries Inc. to be a bit more open-minded and take broader aspects in consideration and make things fairer for the divisions and the upcoming projects as well.