Case 10-2

Assessing Foreign Subsidiary Performance in a World of Floating Exchange Rates

General Electric Companys worldwide performance evaluation system is based on a policy of decentralization. The policy reflects its conviction that managers will become more responsible and their business will be better managed if they are given the authority and necessary tools to budget and achieve a targeted net income in dollar terms. Moreover, decentralization permits the company to overcome the difficulty of centrally exercising detailed control over its large and diverse operations. Foreign affiliate managers, like their domestic counterparts, are accountable for dollar income, a practice not followed by many MNCs. In the words of one financial executive, Although many U.S. corporations are decentralized in their U.S. operations, they seem to be less so with regard to their foreign operations.

One reason may be the concern as to whether foreign managers are sufficiently trained in some aspects of international finance, such as foreign exchange exposure management. We feel this is essential training, and our people get that training.

General Electric does not have any rigid standards for comparing the performance of its affiliates. Strategic and operating plans are agreed upon for each business, including financial targets. Like most other companies, GE generally requires a higher rate of return from investment proposals in riskier countries and has a system of ranking countries according to relative risk. A proposed investment in a high-risk area will have more difficulty being approved and will generally require a higher ROI, but approval depends on both the forecasted ROI and the companys total strategic objectives in each country.

The system of budgeting and forecasting extends five years into the future. The first year of the long-range forecast becomes a preliminary budget for the year ahead. A year later the budget is revised, a comparison is made between it and the original forecast, and changes are accounted for.

Measurement of an affiliated companys performance is related to the objectives of its strategic plan and the annual budgets that are derived from the plan. The primary financial measure is success in achieving the affiliates committed dollar net income. Other measurements include ROI (calculated as the sum of reported net income plus after-tax interest expense, divided by the sum of net worth plus borrowings), net income to sales ratios, market share, inventory and receivable turnover rates, and currency exposure.

While the performance of both an affiliate and its manager are measured primarily on bottom-line results, the review of the manager includes other measurements. Assessments include how well the manager has dealt with government relations, the progress made toward achieving certain targets such as increasing market share, and success in maintaining good employee relationships.

These measurements are based on the strategic plan and targets that were established between the manager and parent company supervisor at the start of a period.

GE conducts periodic operating reviews where each manager is reviewed by the level above. The focus is on planning, results, and most recent estimates. This evaluation process provides corporate management with an opportunity to determine whether short-term actions are being taken at the expense of long-range goals.

To minimize currency exposure, GE finances fixed assets with equity and holds the affiliate responsible for maintaining a balanced position on working capital. The policy is modified as necessary for varying circumstances.

Unlike MNCs that have centralized the financing and exposure management functions at the head office, GE makes exposure management a responsibility of its local managers, overseen by sector and corporate personnel. To avoid the transaction costs of having, for example, a French affiliate hedge its position by buying French francs forward, GE has provisions for internal hedging arrangements. Corporate treasury obtains currency exposure data from all affiliates and provides needed information on offsets. Therefore, units can execute a hedging agreement between themselves without going to outside sources.

In setting the budget, the affiliates manager uses the exchange rate he expects to prevail. General Electric believes that, although predicting rates of exchange is not an exact science, the managers of its foreign businesses have the necessary authority and tools to take those actions that will enable them to achieve their budgeted income. These tools include hedging and pricing decisions. The manager can not only raise prices, cut costs, lead payments, lag receivables, borrow locally, and remit dividends quickly but he can also take out forward contracts if they are available.

The affiliate manager has the responsibility and authority to protect the unit against currency fluctuations and, therefore, is accountable for dollar profits regardless of exchange rate changes.

According to a company spokesperson: If an unexpected devaluation occurs, the affiliates performance is still measured in terms of dollar income vis a vis budget. GE considers changes in the rate of exchange in the same way as other risks that occur in a country. For example, if an affiliates sales are less than those budgeted for because of a recession in that economy, countermeasures are available to the affiliate. If one contends that these things are not controllable, how does one manage a company? Were not saying its controllable in the sense that it can be prevented from happening, but it is susceptible to countermeasures before and after the event occurs.

Required

2. Critically evaluate the strengths and weaknesses of each companys approach to the performance evaluation of its foreign managers as it relates to the problem of fluctuating currency values.