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Specific Knowledge And Divisional Performance Measurement

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  • Michael C. Jensen
  • William H. Meckling

Abstract

This paper discusses five common divisional performance measurement methods—cost centers, revenue centers, profit centers, investment centers, and expense centers—and provides the beginnings of a theory that attempts to explain when each of these five methods is likely to be the most efficient. The central insight of the theory is that each of these methods offers an alternative way of aligning decision‐making authority with valuable “specific knowledge” inside the organization. The theory suggests that cost and revenue centers work best in cases where headquarters has good information about cost and demand functions, product quality, and optimal output mix. Profit centers—defined as business units whose managers have responsibility for overall profits, but not the authority to make major capital spending decisions—tend to supplant revenue and cost centers when the line managers have a significant informational advantage over headquarters and when there are few interdependencies (or “synergies”) between divisions. Investment centers—that is, profit centers in which unit managers are allowed to make major investment decisions—tend to prevail when the activity is capital‐intensive and when it is difficult for headquarters to identify the value‐maximizing investment strategy. In evaluating the performance of profit centers, rate‐of‐return performance measures like RONA (return on net assets) are likely to be effective when unit managers have little influence over the level of new investment. But, in the case of investment centers, Economic Value Added, or EVA, is likely to be the most effective single‐period measure of performance because it is best designed to encourage value‐maximizing investment decisions.

Suggested Citation

  • Michael C. Jensen & William H. Meckling, 1999. "Specific Knowledge And Divisional Performance Measurement," Journal of Applied Corporate Finance, Morgan Stanley, vol. 12(2), pages 8-17, June.
  • Handle: RePEc:bla:jacrfn:v:12:y:1999:i:2:p:8-17
    DOI: 10.1111/j.1745-6622.1999.tb00004.x
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    Cited by:

    1. Benito Arruñada, 2017. "How to Make Land Titling more Rational," Working Papers 983, Barcelona School of Economics.
    2. Brian D. Knox, 2021. "A replication about cause–effect linkage benefits and managers’ strategic judgments," Journal of Management Control: Zeitschrift für Planung und Unternehmenssteuerung, Springer, vol. 32(2), pages 225-251, June.
    3. Kruis, Anne-Marie & Sneller, Lineke, 2013. "International Divider Walls," Journal of Accounting Education, Elsevier, vol. 31(1), pages 31-52.
    4. Konstantinos J. Liapis, 2010. "The Residual Value Models: A Framework for Business Administration," European Research Studies Journal, European Research Studies Journal, vol. 0(1), pages 83-102.
    5. Der-Fang Hung, 2015. "Sustained Competitive Advantage and Organizational Inertia: The Cost Perspective of Knowledge Management," Journal of the Knowledge Economy, Springer;Portland International Center for Management of Engineering and Technology (PICMET), vol. 6(4), pages 769-789, December.
    6. Martin Munene Mutembei & Peter Paul Kithae, 2023. "Effect of Human Resource Planning and Leadership Styles on Performance Contracting in Public Organizations in Kenya," International Journal of Research and Innovation in Social Science, International Journal of Research and Innovation in Social Science (IJRISS), vol. 7(11), pages 489-506, November.

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