Performance Evaluation of Foreign Subsidiaries

Table of Contents

List of Abbreviations

List of Figures and Tables

1 Introduction

2 Theoretical Background of Performance Evaluation
2.1 Theoretical Concepts of Performance Evaluation
2.2 Performance Evaluation in Multinational Corporations

3 Designing an Effective Performance Evaluation System for MNCs
3.1 Treatment of the Foreign Operation
3.2 Separating Managerial and Subsidiary Performance
3.2.1 Noncontrollable Factors in the External Environment
3.2.2 Noncontrollable Factors in the Internal Environment

4 Measures for Performance Evaluation of Foreign Subsidiaries
4.1 Financial Performance Measures
4.2 Nonfinancial Performance Measures

5 Conclusion

Reference List

List of Abbreviations

illustration not visible in this excerpt

List of Figures and Tables

Figure 1 Environmental Factors Influencing the Operating Environment of Foreign Subsidiaries

Figure 2 Financial Measures of Performance Evaluation of Foreign Subsidiaries

Figure 3 Nonfinancial Measures of Performance Evaluation of a Foreign Subsidiary

Table 1 Matrix of Exchange Rate Combinations

1 Introduction

Long before the globalisation had become a buzz word and an impetus for companies to invest abroad, enterprises enlarged their “business playing field” into foreign countries for various reasons, such as to capture a new market, to secure resources, or to take ad- vantage of local cost levels. Therefore, subsidiaries are heavily involved in the value creation process for and within multinational corporations (MNCs). However, despite the fact that the measurement of performance is crucial for globally active companies not only in steering the value creation for the MNC but also, for example, in fostering international expansion or guiding resource allocation, MNCs differ significantly in the extent to which they are aware of the performance of their subsidiaries.

Due to the fact that strategic decisions regarding the global expansion of a MNC require a wide and clear information basis to be able to assess how successfully a foreign sub- sidiary has conducted its business or under what possibly unfavourable environmental conditions the business results were achieved, multinational enterprises have to imple- ment a system for evaluating the performance of their foreign subsidiaries and their management. Therefore, this paper aims to analyse the central aspects to consider in the evaluation of the performance of foreign subsidiaries.

This paper is divided into five chapters. After a short introduction to the theoretical background of performance evaluation in chapter 2, the paper continues in chapter 3 with the central issues of an effective performance evaluation system for foreign sub- sidiaries with a clear focus on the aspect of separating managerial and subsidiary per- formance. Then chapter 4 illustrates the measures used for evaluating foreign subsidiary performance. Finally, the paper concludes by emphasising that an MNC can properly evaluate the performance of it foreign subsidiaries only by considering the specific envi- ronmental factors of the foreign country, separating managerial and subsidiary perform- ance, and supplementing financial with nonfinancial measurements.

2 Theoretical Background of Performance Evaluation

2.1 Theoretical Concepts of Performance Evaluation

To assess whether objectives are being achieved and to guide subsequent actions based on the previous actions, the control system in any organization must include certain per- formance evaluation techniques such as gathering, summarizing, and analysing informa- tion. Mueller, Gernon, and Meek (1994) define performance evaluation, which can be seen as a key management control task, as “the periodic review of operations to ensure that the objectives of the enterprise are being accomplished” (p. 150). Performance evaluation can be understood as a cumulative consideration of factors, which may either be subjective or objective, to determine a representative indicator or appraisal of an or- ganization’s performance in reference to a preassigned standard over a given period of time. A corporation’s performance evaluation system is an essential and integral part of its financial control system and also serves as a basis for rewarding employees.

To efficiently and effectively monitor and manage the activities of an organization a variety of control and coordination mechanisms are usually applied (Kutschker & Schmid, 2005). Baliga and Jaeger (1984) distinguish between output and behaviour as two possible objects of control. While behaviour control leads to a focus on the activi- ties undertaken to attain certain results, output control is wholly concentrated on the results at the end of an activity chain. In the case of output control, performance is achieved when certain targets are fulfilled. Hence, output control is frequently termed performance control since what is evaluated is similar or the same as the actual output (Mintzberg, 1979).

The role performance evaluation as a control mechanism eventually plays is different among corporations and influenced a great deal by the individual control mix of the organization and the specific conditions that affect the use of a control system. By way of example, output control can only be applied as an effective control mechanism when certain output measures actually exist (Snell, 1992).

2.2 Performance Evaluation in Multinational Corporations

Multinational corporations with globally allotted value chain activities have an espe- cially strong need for well-organised accounting systems that accurately monitor and report the results of the corporations’ worldwide operations that contribute to their overall performance (Porter, 1986). Based on the gathered data, performance evaluation is undertaken in order to ascertain and review the business development of the corpora- tion as a whole and of the individual business units and subsidiaries for a given period of time. The deliverables of this evaluation are of great importance to the management because they serve, on the one hand, as a foundation for analysing the profitability of current operations and, on the other hand, as a means to identify areas that need closer attention. In addition, they contribute to the elaboration of future business strategies that aim to further enhance the performance of the business (Chung, Gibbons, & Schoch, 2000). Performance evaluation in general is a difficult issue that becomes even more complex in an international context due to issues that are unique to foreign operations.

A well-organised performance evaluation system is embedded at the level of each indi- vidual subsidiary and serves the management of the MNC as an integrative and coordi- native mechanism for the organization of the corporation (Chang & Taylor, 1999). It evaluates the market performance of a foreign operation within its given environment and its performance within the corporation as a whole (Andersson, Forsgren, & Peder- sen, 2001). Furthermore, performance evaluation allows for comparing subsidiaries with each other by means of selected measures to provide a basis for optimising the allocation of resources throughout the corporation (Czechowicz, Choi, & Bavishi, 1982).

3 Designing an Effective Performance Evaluation System for MNCs

An effective performance evaluation system is central to a proper performance evalua- tion of foreign subsidiaries. However, due to necessary adaptations to specific back- grounds and strategic objectives of an individual organization, neither established guidelines nor a universal performance evaluation system exists. Hence, the organiza- tion of an effective performance evaluation system for foreign subsidiaries presupposes the consideration of the following questions: Should foreign operations be evaluated as cost, profit, or investment centres? How can managerial and unit performance be evalu- ated independently from each other? In this context, how do environmental circum- stances affect the process of performance evaluation? Finally, which measure(s) will be the basis for evaluating performance in order to achieve a valuable result? While the first three questions are discussed in sections 3.1 and 3.2, the important question of which performance measures to employ is discussed in chapter 4.

3.1 Treatment of the Foreign Operation

The concept of responsibility accounting distinguishes between different spheres of ref- erence to place performance evaluation into a manageable context. The responsibility centres have control over costs and/or revenues and over which inputs (resources) and outputs (products, services, or revenues) can be allocated. According to this concept, an MNC must decide whether a foreign operation will be evaluated as a cost centre, a profit centre, or an investment centre since this decision determines the exact techniques and measures by which the foreign subsidiary has to be assessed. Each of these types of centres is different in terms of complexity of control, structure, and purpose compared to the others (McWatters, Morse, & Zimmerman, 2001).

Cost centres form the basic sphere of the responsibility accounting concept as far as controls and objectives are concerned. Usually they are not permitted to dispose of ex- isting assets or purchase new assets. Cost centres have to reach the goal of maximising outputs, in both quality and quantity, within the constraints specified by time and effort, standard cost, flexible budget, and similar systems, or they must produce a specified amount with predetermined quality at the lowest possible outlay. Thus, responsibility is only assigned for cost control and reduction and not for the creation and enhancement of sales. To accomplish improved control and evaluation in practice, the structure of the cost centre is broken down into its basic elements. Responsibility centres classified as cost centres have the objective of concentrating on costs that are controllable at the lev- els being addressed. Noncontrollable costs, however, are excluded from consideration. Performance evaluation of cost centres occurs mainly on a financial basis that assesses deviations from predefined standards. Nonfinancial measures such as the number of machine breakdowns, employee turnovers, and the like are also applied quite frequently (Doupnik & Perera, 2007; Elsharawy, 2006).

A unit or a division within an MNC that has control over costs as well as over revenues can be classified as a profit centre according to the responsibility accounting concept (Miller, 1979). This definition requires that the unit have the authority, on the one hand, to produce or purchase the trade goods and services it requires where and when it wants and, on the other hand, to market and price its products and outputs to external custom- ers (anywhere or within defined territories or regions) independently from the approval of headquarters. Only larger investments such as capital acquisitions and expenditures over specified amounts need to be sanctioned by headquarters. Often it is not possible for a division or a unit to act as a profit centre since it may have strategic importance other than generating a profit (e.g., captivation of raw material in the mining industry) or its corresponding classification is not compatible with the transfer pricing concept of the MNC (see section 3.2.2). Consequently, the interdependencies that exist between the units and divisions of a multinational organization actually prohibit their classification as true profit centres. The performance evaluation of profit centres mainly concentrates on profit. Profit is thereby regarded as an absolute measure that is of even greater im- portance when there is a basis for comparison (e.g., the results of previous periods or the profits of other units of the organization) (Doupnik & Perera, 2007; Elsharawy, 2006).

According to the concept of responsibility accounting, the classification of a subsidiary as an investment centre is simply an extension of the previously described profit centre. Just like the profit centre, an investment centre has control over outputs, inputs, and the assets utilised to generate profits. A manager of an investment centre basically has the same responsibilities as the manager of a profit centre (freedom to purchase, produce, and market) except that he also has the responsibility for investment decisions. Only a few divisions of globally operating MNCs are bona fide investment centres, which is primarily due to the fact that investment decisions and the approval of major capital acquisitions and expenditures over a predetermined amount are typically within the pur- view of headquarters. Performance evaluation of investment centres mainly concen- trates on return on investment (ROI) figures (Doupnik & Perera, 2007; Elsharawy, 2006).

3.2 Separating Managerial and Subsidiary Performance

To obtain valid results in the process of evaluating performance in MNCs, it is essential to differentiate between the performance of the subsidiary and the performance of its management. Although this is a difficult task, it turns out to be very important (Elsharawy, 2006). Good subsidiary performance can be achieved with poor manage- ment performance and vice versa due to the fact that various factors influence the per- formance of subsidiaries. Hence, a performance evaluation system should support the separation of managerial and subsidiary performance in order to appropriately remuner- ate good managers and not mistakenly reward poor managers. It is therefore essential to measure the relative contribution of foreign subsidiary managers to the performance of MNCs (Abdallah, Firoz, & Ekeledo, 2005; Doupnik & Perera, 2007).

Central to this discussion is the fact that a foreign subsidiary’s performance measures are influenced by various factors that are beyond the control of the local manager or that he is not allowed to attempt to manage (Hamilton, Taylor, & Kashlak, 1996). Thus, ac- cording to the concept of responsibility accounting, which was already mentioned in section 3.2., “costs, revenues, assets, and liabilities should be traced to the individual manager who is responsible for them. Individual managers should not be held responsi- ble for costs over which they have no control, nor should they be given credit for uncon- trollable revenues.” (Doupnik & Perera, 2007, p. 548) Consequently, MNCs have to identify these uncontrollable variables in the performance evaluation of foreign subsidi- aries and their management and should exclude them from performance evaluation. In general, these noncontrollable factors can be classified as belonging to either the exter- nal or the internal environment.

3.2.1 Noncontrollable Factors in the External Environment

The noncontrollable factors in the external environment of foreign subsidiaries are rooted in the local business environment. For example, subsidiaries are influenced not only by various environmental factors of the host country but also by foreign currency exchange rates.

[...]