- 20 Marks
Question
Kenkah Ltd provides buffer storage for many companies throughout the country. The company has two divisions, namely Abura and Keta. Each division is autonomous and makes its own long-term investment decisions.
Kenkah Ltd measures the performance of its divisions using Return on Investment (ROI), calculated using controllable profit and average divisional net assets. The company has a cost of capital of 12% but a targeted ROI of 18%. The divisional managers’ annual bonus is determined by the extent to which the ROI earned by the division exceeds the target.
At the beginning of the year, the two divisions, Abura and Keta, bought assets worth GH¢12.5 million and GH¢18.2 million respectively. The assets have a five-year life span with no residual value. The company uses the straight-line depreciation method. The other assets are being controlled by the head office.
Over the years, Kenkah Ltd has used ROI in evaluating the performance of managers. However, to discourage dysfunctional behavior, Kenkah Ltd is considering introducing Residual Income (RI) as a performance measure. Like ROI, RI is calculated using controllable profit and average divisional assets.
The current year’s draft operating statement is shown below:
| Abura (GH¢000) | Keta (GH¢000) | |
|---|---|---|
| Sales | 15,350 | 17,020 |
| Less controllable Variable Cost | 7,505 | 8,950 |
| Contribution | 7,845 | 8,070 |
| Less Fixed Cost [i) & ii)] | 6,335 | 6,910 |
| Profit | 1,510 | 1,160 |
Additional Information:
i) Included in fixed costs are the current year depreciation charges of GH¢3,125,000 and GH¢4,550,000 for division Abura and Keta, respectively. Twenty percent (20%) of the depreciation cost in each division is from assets owned and controlled by the head office.
ii) Head office allocates some of its overhead costs to the two divisions using activity-based costing. These costs have been included in the fixed costs and amounted to GH¢210,000 and GH¢230,000 for Abura and Keta, respectively.
iii) The Management Accountant stated at a recent board meeting that “Responsibility accounting is based on the application of the controllability principle.” Hence, he would resist any attempt by management to deviate from this basic principle.
Required:
a) Explain the “controllability principle” and why its application is difficult in practice.
(4 marks)
b) Calculate the current year controllable profit for both divisions of Kenkah Ltd.
(4 marks)
c) Calculate the current year ROI for each of the two divisions of Kenkah Ltd.
(3 marks)
d) Calculate the current year RI for each of the two divisions of Kenkah Ltd.
(4 marks)
e) Discuss the performance of the two divisions for the year.
Answer
a) Controllability is defined as “the degree of influence that a specific manager has over costs, revenues, investments, or other items in question”.
The controllability principle is that managers should only be held responsible for costs, revenue, profit, or investment that they have direct control over. So, for example, a divisional manager would not be held responsible for the allocation of central costs or cost of depreciation to her department if she has no control over the incurrence or magnitude of these costs. Under this principle, it would be held that dysfunctional consequences would arise if managers were held accountable for costs over which they have no control.
Holding managers accountable/responsible for costs outside their control may encourage them to become more involved with such issues and, as a result, the total cost may be reduced, or the goods or services may be provided more efficiently.
However, there is difficulty in classification or drawing the line between cost which is controllable and cost which is uncontrollable. Furthermore, holding managers responsible for items outside their control may be demotivating.
(4 marks)
b) Current year controllable profit:
| Abura (GH¢000) | Keta (GH¢000) | |
|---|---|---|
| Sales | 15,350 | 17,020 |
| Less: Variable cost | 7,505 | 8,950 |
| Contribution | 7,845 | 8,070 |
| Less: Division Depreciation** | (2,500) | (3,640) |
| Less: Other Overheads** | (3,000) | (2,130) |
| Controllable Profit | 2,345 | 2,300 |
Notes:
- Depreciation: 80% of GH¢3,125,000 for Abura and 80% of GH¢4,550,000 for Keta.
- Other Overhead: GH¢6,335,000 – (GH¢3,125,000 + GH¢210,000) for Abura and GH¢6,910,000 – (GH¢4,550,000 + GH¢230,000) for Keta.
(4 marks)
Alternative Solution:
| Abura (GH¢000) | Keta (GH¢000) | |
|---|---|---|
| Net profit | 1,510 | 1,160 |
| Add back HQ depreciation | 625 | 910 |
| Add back HO Overhead cost | 210 | 230 |
| Controllable profit | 2,345 | 2,300 |
Workings:
- Depreciation: 20% of GH¢3,125,000 = GH¢625,000 for Abura and 20% of GH¢4,550,000 = GH¢910,000 for Keta.
(4 marks)
c) ROI Calculation:
| Abura (GH¢000) | Keta (GH¢000) | |
|---|---|---|
| Controllable profit | 2,345 | 2,300 |
| Average Net Assets | (12,500+10,000)/2 | (18,200 + 14,560)/2 |
| ROI (%) | 20.84% | 14.04% |
| (3 marks) |
d) Residual Income (RI) Calculation:
| Abura (GH¢000) | Keta (GH¢000) | |
|---|---|---|
| Controllable profit | 2,345 | 2,300 |
| Less: Imputed interest | 1,350 | 1,965.60 |
| RI (GH¢000) | 995 | 334.40 |
| (4 marks) |
e) Comments on Performance:
If a decision about whether to proceed with the investments is made based on ROI, it is possible that the manager of Division Keta will reject the proposal whereas the manager of Division Abura will accept the proposal. This is because while division Abura has a ROI of 20.84%, higher than the target of 18%, which entitles the manager to a bonus, Division Keta would reject the investment because its ROI is 14.04%, lower than the target of 18%, hence not entitled to a bonus.
If they used residual income (RI) in order to aid the decision-making process, both proposals would be accepted by the divisions since both have a positive RI.
(5 marks)
- Tags: Controllability Principle, Performance Measurement, Responsibility Accounting, RI, ROI
- Level: Level 2
- Topic: Performance analysis
- Series: JULY 2023
- Uploader: Dotse