The Division That Beats Its Budget and Destroys Value
Meridian Components operates three divisions. Division B has reported a return on investment (ROI) of 22% for three consecutive years against a group target of 15%, and its manager has just been awarded a bonus. Group finance is uneasy. Division B's net operating assets are $48m, of which $11m is a legacy automated line that is fully depreciated and still running at high utilisation. Group cost of capital is 11%. A new contract requires $9m of investment in a modern line that would generate annual operating profit of $1.35m for eight years. Division B's manager has declined it, arguing it would dilute divisional ROI. The group's other divisions trade at an average ROI of 13%. The CEO has asked for an analysis before the next board meeting, noting that 'everyone is hitting their targets but the share price is flat'.
1. Evaluate whether Division B's manager is acting rationally and whether the performance measure is at fault. Support with calculations.
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Behaviour is rational given the measure. Current divisional profit = 22% × $48m = $10.56m. Accepting the contract gives profit of $12.56m on assets of $57m = 22.04% - essentially unchanged only because the numbers are close; on a stricter reading, incremental ROI = 1.35/9 = 15%, well below the division's 22% average. Any manager judged on average ROI has an incentive to reject projects earning between the cost of capital (11%) and the current ROI (22%). The rejection destroys value: the project earns 15% vs 11% required, i.e. a positive residual income of 1.35 − (9 × 11%) = $0.36m per year.
The measure is at fault, not the manager. ROI is a ratio that penalises asset growth and is distorted by the age of assets. The fully depreciated $11m line inflates Division B's ROI artificially - its book value understates the economic capital employed. Comparing Division B (22%) with divisions averaging 13% is meaningless when asset ages differ.
Recommendations: (1) Switch to residual income or EVA so that any project above 11% is accepted; RI for the project is +$0.36m. (2) Use divisional cost of capital reflecting risk. (3) Re-base asset values or use gross replacement cost to neutralise depreciation-age distortion. (4) If ROI is retained, judge managers on incremental ROI against the hurdle, not average ROI. (5) Align bonus to group value creation to remove the incentive to hoard capital.
2. The CEO observes that all divisions hit target yet shareholder value is flat. Explain how this can occur and what it reveals about the budgeting and target-setting process.
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Targets have been captured by the incumbents. If every target is met but value is flat, the targets are almost certainly set at levels that do not require value creation - they may be based on prior-year results plus an increment ('incremental budgeting'), or negotiated by managers who know the information asymmetry favours them. Budget slack absorbs the gap between achievable and committed performance.
Ratchet and gaming effects. Managers who beat target risk a higher target next year, so they defer or smooth performance. Division B's rejection of a positive-NPV project is a textbook example: the target is defended, not the business.
What to change:
- Set targets from external benchmarks and zero-based or activity-based build-ups, not last year plus x%.
- Introduce a balanced scorecard so financial target achievement is not the sole bonus trigger.
- Use relative targets (peer group, cost of capital spread) and multi-year rolling targets to reduce ratchet gaming.
- Separate the target-setting and performance-review functions, and require capital-allocation decisions to be judged on NPV/RI regardless of divisional ROI impact.
- Publish a capital charge so that 'hitting target' means 'earning above the cost of capital'.