ROA vs. Balanced Scorecard in Performance Evaluation

Introduction

Enager Industries Ltd (Enager) was a relatively young company whom manufactured and produced products/services within three divisions- Consumer Products, Industrial Products and Professional Services. Consumer Products, the oldest among the three divisions in Enager, designed, manufactured and marketed a line of houseware items. Industrial Products built one -of -a- kind machine tools to customer specifications. Professional Services, the newest among the three, provided several kinds of engineering services and this division had grown rapidly because of its capability to perform "environmental impact" studies.

Each division was treated as an essentially independent company but all new project proposals requiring investment in excess of $1,500,000 had to be reviewed by the Chief Financial Officer, Henry Hubbard.

Analysis

Carl Randall, Enager's president, had transformed the three distinctly separate divisions from being treated as profit centers into investment centers in 1992 at the urging of Henry Hubbard. The change enabled the three divisions to use ROA (Return on Assets) as a performance measure of the success of each division.

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The ROA was defined to be the division's net income divided by its total assets the division used to generate its profits.

The net income for a division was calculated by taking the division's "direct income before taxes", subtracting the division's share of corporate administrative expenses and its share of income tax expenses. On the other hand, the total assets of a division was calculated by taking the division's assets, including receivables and the allocated corporate-office assets, including the centrally controlled cash account, based on the basis of divisional revenues.

In addition, all fixed assets were recorded at their balance sheet values- original cost less accumulated straight line depreciation. Based on these calculation techniques, the sum of divisional net income and assets were equal to the corporate net income and assets respectively.

Hubbard believed that a company like Enager should have a gross return on assets, defined as equal to earnings before interest and taxes divided by assets, of at least 12 percent, given the interest rates the company had had to pay on its debt. He told each division manager that the division was to try to earn a gross return of 12 percent and new investment proposals would have to show a return of at least 15 percent in order to be approved. The company had managed to increase its ROA from 5.2 percent to 5.7 percent and its gross return from 9.3 percent to 9.5 percent from 1991 to 1992.

However, several issues arose with regard to this new method. First, there was a problem occurred between Sarah McNeils, the product development manager of Consumer Products Division, and Hubbard while her new proposal demonstrated a return of thirteen percent (calculated in Exhibit 1) at different point of selling prices and units, however, it was rejected by Hubbard because it did not meet the 15 percent return he had set for all divisions.

Another problem that arose within Enager was between the Industrial Products Division, and the president. The problem occurred when the president was unsatisfied with the ROA of Industrial Products Division and tried to put pressure on the general manager of the division. A conflict arose between them when the division manager argued that the division could have achieved a better ROA if they had a lot of old assets as Consumer Products Division did.

Furthermore, in 1993, ROA fell from 5.7 percent to 5.4 percent and gross return dropped from 9.5 percent to 9.4 percent. However, at the same time, return on sales rose from 5.1 percent to 5.5 percent and return on owners' equity also increased from 9.1 percent to 9.2 percent. Comparing the performance based on ROA in this year, Professional Services Division exceeded the 12 percent gross return target; Consumer Products Division's gross ROA was 10.8 percent; the Industrial Products Division's gross ROA was only 6.9 percent. The president was disappointed and puzzled about the results of ROA in 1993.

I recognize that these problems were mainly resulted from inefficient use of ROA (Return on Assets) as a performance measurement method in Enager. Firstly, the president and the CFO should not set a target gross ROA rate of 15 percent for three different divisions that were obviously operating in different industries--Consumer Products Division produced a line of high volume low cost houseware items; Industrial Products Division was a large "job shop" who built one-of- kind machine tools to customer specifications, and Professional Services mainly provided engineering services. The three divisions had different amount of assets, nature of business and profitability and it is unreasonable to compare them with a fixed target rate of ROA.

Second, the executives were making a mistake by using balance sheet values when calculating the fixed assets of each division. This had disadvantaged the divisions that contained more new assets with lesser depreciation values since ROA would be reduced due to a larger denominator resulted from higher values in assets. The president did not understand the comment from the manager of Industrial Products Division about the older a division's assets would result in a higher ROA. And it was unfair to measure a division's success based on the age of a division's assets, and consequently, this would frustrate the manager in a division with a lot of new assets.

Third, it was unreasonable to allocate corporation's assets and expenses to divisional assets and net income based on revenue generated by the division. For example, if Professional Services Division was earning more than other two divisions, Professional Services' return would be reduced by this inaccurate allocation method while more allocated corporate expenses would decrease the numerator and more allocated corporate assets would increase the denominator of the ROA calculation, subsequently, the ROA would not fully reflect division's true performance.

Recommendation and ImplementationCurrently, Enager is using ROA as a method of performance evaluation of the three divisions. As previously illustrated, this is an inefficient use of ROA since total divisional assets and net income are influenced by varying components. ROA in its current form does not paint an accurate picture of the overall performance of the company. For example, division contains more assets is obviously disadvantaged since their ROA would be subsided by a larger amount of denominator. In addition, the company could not yield the highest revenues by setting a benchmark ROA rate in which all divisions are encouraged to attain. For example, McNeils' proposal was rejected because it did not meet the 15 percent return required by Hubbard. However, McNeil's proposal demonstrates a return of 13 percent, and favourable residual income at any point under the 13 percent Weighted Average Capital Cost. Enager had missed the opportunity to increase the earnings per share of the company due to incorrectly setting a target rate for all three divisions.

The company could choose an alternative measure of divisional performance such as Balanced Scorecard. Balanced Scorecard is a performance measurement system which measures a division's activities in terms of its goals and strategies rather than a ratio like ROA. The management could obtain a broad-based view of the performance of a division from both divisional financial and non financial elements. In establishing the Balanced Scorecard, executives must choose a mix of measurements that accurately reflect the important factors that will determine the success of the divisional strategy; show the relationships among the individual measures in a cause-and-effect manner; and provide a comprehensive view of the current condition of the division. The Balanced Scorecard promotes a balance among different strategic measures in an effort to achieve goal congruence, thus fostering employees to act in the organization's best interest.

If Enager were to use Balanced Scorecard, divisions would be able to have the same profit objectives by focusing on the same goals of the company but not just focusing on a fixed target return rate. For example, by introducing Balanced Scorecard, this would allow McNeils to carry out her proposal that would benefit the company as a whole but may have a lowering impact on her divisional ROA. Another advantage of Balanced Scorecard, unlike ROA, is that the comprehensive value of the division is reflected in this method. This allows executives of Enager to better compare between divisions operated in different industries since the performance measurement system takes different perspectives such as financial, customer, internal business and innovation of the division into account.

After analyzing the two alternatives I recommend that Enager implement Balanced Scorecard method for their division performance measures. I feel that ROA reduces the comparability between divisions, limits expansion for the company and the individual divisions, and consequently it does not provide fair performance measurements for divisions and the company. For example, ROA fell from 5.7 percent to 5.4 percent from 1992 to 1993 but at the same time, return on sales rose from 5.1 percent to 5.5 percent and return on owners' equity also increased from 9.1 percent to 9.2 percent. This suggests that ROA does not fully depict the true performance of the company.

Balanced Scorecard, on the other hand, is a better method for Enager for assessing divisional performance because it effectively depicts performance from financial and non-financial perspectives. This is a better measurement method for Enager especially its divisions were operating in different industries. Furthermore, Balanced Scorecard promotes goal congruence because divisions will not only be working to better themselves, but the decisions that are made will benefit the company as a whole.

ConclusionEnager Industries Ltd was a relatively young company whom manufactured and produced products/services within three divisions. The company was using ROA method in assessing divisional performance. There were a few problems and conflicts arose within the company due to inefficient use of ROA. Switching to Balanced Scorecard will help Enager obtain stronger goal congruency while alleviating some inefficiency in performance measure created by ROA.

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