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  • 15 Marks

MA – Dec 2023 – L2 – Q1a – Divisional performance

This question assesses the ROI and RI of two divisions, Ken and Yon, and compares their performance.

Ken and Yon are two divisions of a large company that operate in similar markets. The divisions are treated as investment centres, and every month each division prepares an operating statement and submits it to the parent company. Operating statements for the two divisions for October are stated below:

Operating Statements for October Ken (GH¢000) Yon (GH¢000)
Sales revenue 900 555
Variable costs 345 312
Controllable fixed costs (includes depreciation on division assets) 433 222
Uncontrollable apportioned central costs 15 5
Divisional net assets for the year 9,760 1,260

The company currently has a target return on capital of 12% per annum. However, the company believes its cost of capital is likely to rise and it is considering increasing the target return on capital. Currently, the performance of each division and the divisional management are assessed primarily based on Return on Investment (ROI) using controllable profit.

Required:

i) Calculate the annualised Return on Investment (ROI) for divisions Ken and Yon, and discuss their relative performances. (6 marks)
ii) Calculate the annualised Residual Income (RI) using controllable profit for divisions Ken and Yon, and evaluate their division’s performances. (6 marks)
iii) Using appropriate ratios, evaluate the efficiency of the two divisions. (3 marks)

i) Return on Investment (ROI):

Discussion of relative performance:

  • Division Yon has the highest return on investment (20%) in comparison to division Ken (15%).
  • Both divisions exceed the target of 12% per annum set by the parent company. However, division Ken will be at greater risk if the target return on investment is increased.
  • Both divisions are profitable and generate a positive contribution for the group.
  • In absolute terms, division Ken is larger in terms of net assets and generates greater absolute profit than division Yon.

ii) Residual Income (RI):
Residual income = Profit before interest and tax – (Capital employed × cost of capital)

Division Ken (GH¢ million) Yon (GH¢ million)
Profit before interest and tax (annualised) 1.464 0.252
Capital employed cost of capital 1.171 0.151
Residual Income 0.293 0.101

Evaluation:

  • Division Ken contributes greater wealth for the group, demonstrated by a higher residual income.
  • Residual income is superior as it accounts for the absolute size of wealth generated rather than just relative returns.

iii) Efficiency ratios:

Division Ken is more operationally efficient with lower variable costs to sales (38.3% vs 56.2% for Yon).

  • 7 Marks

FM – May 2018 – L2 – Q1c – Divisional Performance

Calculate and analyze return on investment and residual income before and after a new investment in a division.

The Bottle Labelling Division of Crush Drink Ltd currently has capital employed of GH¢100,000 and earns an annual profit after depreciation of GH¢18,000. The divisional manager is considering an investment of GH¢10,000 in an asset which will have a ten-year life with no residual value and will earn a constant annual profit after depreciation of GH¢1,600. The cost of capital is 15%.

Required:
Calculate the following and comment on the results.
i) The return on divisional investment, before and after the new investment
ii) The divisional residual income before and after the new investment

i) Return on Divisional Investments
= Divisional Profit / Divisional Investments * 100

Before Investment After Investment
Divisional profit GH¢18,000
Divisional investment GH¢100,000
Divisional ROI 18%

Comment:
The ROI will fall in the short term if the new investment is undertaken. This is a problem which often arises with ROI, as noted in part (b) of this solution.

ii) Divisional Residual Income
= Divisional Profit – (Cost of Capital (15%) * Divisional Investment)

Before Investment After Investment
Divisional profit GH¢18,000
Imputed cost of capital (0.15 * GH¢100,000) GH¢15,000
Divisional RI GH¢3,000

Comment:
The Residual Income will increase in the short term if the new investment is undertaken.

  • 7 Marks

MA – May 2018 – L2 – Q1b – Divisional performance

Compare residual income and return on investment for divisional performance measurement, highlighting their advantages.

Compare and contrast the use of residual income and return on investment in divisional performance measurement, stating the advantages.

 

Contrasting Residual Income & Return on Investment

  • Return on investments is a financial ratio that measures the rate of return of a company’s investments. Companies use ROI to compare the efficiency of a number of investments. Residual income is another approach to measuring the performance of an investment. It is the net operating income an investment earns above the minimum required return on its operating assets.
  • The residual income (RI) for a division is calculated by deducting from the divisional profit an imputed interest charge, based on the investment in the division. The return on investment (ROI) is the divisional profit expressed as a percentage of the investment in the division.
  • It can be difficult to compare the percentage ROI results of divisions if their activities are very different: residual income can overcome this problem through the use of different interest rates for different divisions.
  • Rigid adherence to the need to maintain ROI in the short term can discourage managers from investing in new assets, since average divisional ROI tends to fall in the early stages of a new investment. Residual income can overcome this problem by highlighting projects which return more than the cost of capital.

Comparing Residual Income & Return on Investment

  • Both methods suffer from disadvantages in measuring the profit and the investment in a division which include: Assets must be valued consistently at historical cost or at replacement cost. Neither valuation basis is ideal.
  • Both methods use the same basic figure for profit and investment, but residual income produces an absolute measure whereas the return on investment is expressed as a percentage.
  • Divisions might use different bases to value inventory and to calculate depreciation. Any charges made for the use of head office services or allocations of head office assets to divisions are likely to be arbitrary.

Advantages of ROI & RI

  • Focus management’s attention upon earning the best profit possible on the capital (total assets) available.
  • Serve as a yardstick in measuring management’s efficiency and effectiveness in managing the company as a whole and its major divisions or departments.
  • Tie together the many phases of financial planning, sales objectives, cost control, and the profit goal.
  • Afford comparison of managerial results both internally and externally.
  • Develop a keener sense of responsibility and team effort in divisional and departmental managers by enabling them to measure and evaluate their own activities in the light of the results achieved by other managers.
  • 12 Marks

MA – May 2019 – L2 – Q1b – Divisional Performance

Evaluate divisional performance using ROI and RI and assess the impact of investment decisions on these metrics.

Ayittey Ltd is an organization with two divisions: A and B, each with its own cost and revenue streams. Each of the two divisions is classified as an Investment center. The company’s cost of capital is 12%. Historically, investment decisions have been made by calculating the return on investment (ROI). A new manager who has recently been appointed in Division A has argued that using residual income (RI) to make investment decisions would result in ‘better goal congruence’ throughout the company. The data below shows the current position of the division as at the end of 31 December, 2016:

Details of Projects Project A Project B
Capital required GH¢ 82.8 million GH¢ 40.6 million
Sales generated GH¢ 44.6 million GH¢ 21.8 million
Net Profit margin 28% 33%

The company is seeking to maximize shareholders’ wealth. Assuming that Division A acquires a more efficient asset at GH¢15 million and Division B sold one of its assets with a written down value of GH¢24 million, and profits are expected to increase and decrease by GH¢11 million and GH¢5 million for Division A and B respectively.

Required:
i) Calculate both the current Return on Investment (ROI) and Residual Income (RI) for each of the divisions. (5 marks)
ii) Calculate and comment on the effect of the decision to invest in the new asset and disposal of some assets on the current ROI and RI. (7 marks)

i) Divisional performance measurement using ROI
Division A:
ROI = Net Profit / investment x 100
= 12.49 / 82.8 x 100 = 15.085%

Division B:
ROI = Net Profit / investment x 100
= 7.194 / 40.6 x 100 = 17.72%

Divisional performance measurement using RI
Division A:

GH¢
Net Profit 12.49
Less imputed interest charge (12% @ 82.8) (9.936)
Residual Income (RI) 2.554

Division B:

GH¢
Net Profit 7.194
Less imputed interest charge (12% @ 40.6) (4.872)
Residual Income (RI) 2.322

(5 marks evenly spread using ticks)

ii) Divisional performance after the new investment
Division A:
ROI = Net Profit / investment x 100
= 23.49 / 97.8 x 100 = 24.02%

Division B:
ROI = Net Profit / investment x 100
= 2.194 / 16.6 x 100 = 13.21%

Residual Income after new investment.

A B
Income 23.49 2.194
Cost of capital 11.74 1.992
RI 11.75 0.202

(3 marks)

Comment

  • If a decision about whether to proceed with the investments is made based on ROI, it is possible that the manager of Division A will accept the new proposal whereas the manager of Division B will reject the new proposal. Prior to the new investment Division A had 15.085%, though this is a bit lower than the target rate of return of 16% while Division B had 17.72%. With the new investment Division A’s manager has an ROI of 24.02%, which is above the target rate of return, representing a 37.21% increase in the ROI of division A. Division B has an ROI of 13.21%, which is lower than the target rate of return, representing a 25.45% reduction in the ROI of Division B.
  • However, since Division B’s new ROI of 13.21% is higher than the firm’s cost of capital of 12%, accepting the new investment would encourage goal congruence and improve the firm’s overall performance. Behaviorally, Division B’s manager may not be motivated to venture into the new investment if his rewards are tied to the current level of performance. Accepting the new investment means a reduction in his incentives (bonuses).
  • 8 Marks

MA – May 2021 – L2 – Q1b – Divisional performance, Performance analysis

Evaluate the impact of a new investment on a division’s Return on Investment, Residual Income, and manager’s bonus.

b) Peah is a divisional manager of Monrovia Ltd. He is paid a bonus of 5% on the division’s residual income after charging the bonus. The division is currently considering an additional investment of GH¢200,000 with 10 years useful life but nil residual value. The investment is expected to yield a profit after depreciation of GH¢51,600. This will augment the existing capital employed of GH¢1,050,000 that currently offers GH¢264,400 profit after depreciation annually. The company’s policy is to accept investment projects that provide a return of at least 22%.

Required: i) Calculate the Return on Investment and Residual Incomes of the division before considering the new investment. (2 ½ marks)
ii) Advise the division on whether the new investment should be taken or not. (2 ½ marks)
iii) What will be the percentage change in the bonus of Peah if the new investment is added to the division’s existing operations? (3 marks)

i) Determination of divisional ROI and RI

Calculation of divisional ROI
Before the new investment:
Divisional Profit: GH¢264,400
Divisional Investment: GH¢1,050,000
Divisional ROI: 25.18%

After the new investment:
Divisional Profit: GH¢316,000
Divisional Investment: GH¢1,250,000
Divisional ROI: 25.28%

Calculation of divisional RI
Before the new investment:
Divisional Profit: GH¢264,400
Less imputed interest (22% x GH¢1,050,000): GH¢231,000
Residual Income: GH¢33,400

After the new investment:
Divisional Profit: GH¢316,000
Less imputed interest (22% x GH¢1,250,000): GH¢275,000
Residual Income: GH¢41,000

ii) Advice on the new investment:
Based on the ROI, the new investment is marginally beneficial in the short term as it slightly increases ROI to 25.28%. Based on the RI, it is beneficial as it increases residual income to GH¢41,000. Thus, the new investment should be accepted.

iii) Determination of bonus to the divisional manager:

5% bonus on residual income after charging the bonus.
Before the new investment:
5/105 x GH¢33,400 = GH¢1,590.48

After the new investment:
5/105 x GH¢41,000 = GH¢1,952.38

Percentage change in bonus:
(1,952.38 – 1,590.48) / 1,590.48 x 100 = 22.75%

  • 40 Marks

CSEG – May 2017 – L2 – Q1a – Strategic alternatives, analysis and selection

Analyze Gussie Perry Ltd's environmental policies, mission statement relevance, division performance, and market position using ROI, RI, and Porter's Five Forces.

CASE STUDY: GUSSIE PERRY LTD

Introduction:
Gussie Perry Ltd (GPL) is a long-established divisionalized company with its origins in shipping. The company has been in existence for nearly 120 years and has developed a reputation for reliability and quality service.

The shipping activities in which Gussie Perry Ltd (GPL) is engaged comprise four divisions – cruise, ferry, container, and bulk shipping. The cruise division is engaged entirely in the carriage of passengers, while the ferry division carries passengers and vehicles. The vehicles carried by the ferries range from motor cars to articulated trucks and buses. The container and bulk shipping divisions are engaged in the carriage of freight only.

Organizational Goals:
The company has stated over recent years that it aims to:

  1. Increase its international business to achieve long-term profitability.
  2. Provide the necessary capital investment to support its international operations.
  3. Train and develop the company’s employees.

Environmental and Safety Policy:
Environmental protection is now a key aspect of corporate social responsibility. Pressure on Gussie Perry Ltd (GPL) for better environmental performance is coming from many quarters. The company recently implemented an environmental and safety policy, which is monitored through an audit system, in an effort to ensure that its policies are being executed. It is the aim of the company to have operational standards that match the best industry standards. Training of management, staff, and specialist auditors is seen as a priority within the organization’s environmental and safety policy. This has become a major concern for the company because of customer anxiety about the safety of the ferries.

Financial Results:
In the last financial year, earnings per share were GH¢2.12, producing a dividend cover of 1.15 times. The dividend per share paid by Gussie Perry Ltd (GPL) has remained at the same level for five years. Comparative values for divisional revenue and operating profit are shown in Table 1.

Table 1: Divisional Financial Data

Division Cruise Ferry Container Bulk Shipping
Current year’s revenue (GH¢’000) 5,136 4,002 7,572 750
Previous year’s revenue (GH¢’000) 4,410 3,756 6,306 672
Current year’s operating profit (GH¢’000) 780 650 252 (30)
Previous year’s operating profit (GH¢’000) 528 480 240 (18)
Assets/Capital Employed (GH¢’000) 2,800 2,500 3,200 3,800

During the year, general inflationary levels in the shipping industry were 14% per annum. The company’s cost of capital is 25%.

Extract from the Chairman’s Statement for the Financial Year:
In his statement, Mr. Aaron Yeboah, the Chairman of Gussie Perry Ltd (GPL), commenting on revenue and profit before the inflation adjustment, said the company achieved encouraging results, particularly in the cruise division. The company had taken delivery of a new cruise liner, at a cost of GH¢1,200,000, and has two more on order. Aaron believed that this was an expanding market and considered the company to be in a good position to take advantage of the opportunity. With regard to the ferry division, Aaron expected continued growth, although there was an expectation of potential new entrants due to increased cargo volumes. This contrasted with his view of the declining performance of the container and bulk shipping divisions as shown in Table 1.

Market Information:
Gussie Perry Ltd (GPL) commissioned market research into its cruise and ferry operations. The results of this research indicated that, in recent years, within the cruise liner industry, there has been a change in customer appeal. Traditionally, the main customer base had comprised traders. In the last five years, the cruise division has experienced an increase in its clientele, especially holidaymakers. This stemmed from the promotion of domestic tourism.

Furthermore, the research showed a 15% increase in marine transport, but Gussie Perry Ltd’s market share actually reduced by 4%. The report indicates that the probability of the cruise market continuing to grow was bright. However, there were uncertainties about the future potential of the container and bulk shipping divisions.

Required:

a) Identify FOUR ways in which GPL’s concern for environmental and safety policy can impact on its performance. (4 marks)

b) The Chairman of the company has recently attended a short course on strategic planning. He was particularly interested in the relevance of mission statements to the strategic management process. Explain in FOUR ways how a mission statement is relevant in strategic management. (8 marks)

c) i) Calculate the current return on investment (ROI) and residual income (RI) for each division for the current year. (4 marks)
ii) Assess the performance of each division and advise the management of Gussie Perry Ltd (GPL). (8 marks)

d) With reference to Porter’s Five Competitive Forces model, assess the nature of the cruise and ferry shipping market in which Gussie Perry Ltd (GPL) is engaged. (16 marks)

a) Impact of Environmental and Safety Policy on Performance:

  1. Understanding and managing environmental costs: Environmental costs are often hidden in overheads, and environmental and energy costs are often not allocated to the relevant budgets.
  2. Minimizing accidents and long-term environmental effects: Accidents and long-term environmental effects can result in large financial liabilities.
  3. Cost of capital considerations: Companies with poor environmental performance may face increased costs of capital because investors and lenders demand a higher risk premium.
  4. Corporate reputation and social responsibility: Environmental protection and ethical labor practices are now key aspects of corporate social responsibility, contributing to both the company’s reputation and societal well-being.

(Total: 4 marks)

b) Relevance of Mission Statements in Strategic Management:

  1. Clarifying Organizational Purpose: A mission statement defines the reason why the firm exists, what it aims to achieve, and how it aims to achieve its purpose. This clarity helps guide decision-making and strategy development.
  2. Influencing Organizational Culture: A mission statement expresses the core values and beliefs of the company, shaping the attitudes and behaviors of employees and aligning them with the organization’s goals.
  3. Communicating with Stakeholders: The mission statement communicates the company’s intentions to both internal and external stakeholders, helping to build trust and align expectations.
  4. Guiding Strategic Planning: Mission statements provide a foundation for setting goals, objectives, and strategies. They ensure that the strategic direction of the company is consistent with its core purpose and values.

(Total: 8 marks)

c) i) Calculation of ROI and RI for Each Division:

Residual Income (RI):

ii) Assessment of the Various Divisions
APPENDIX: SUMMARY OF KEY RATIOS FOR THE ASSESSMENT OF THE DIVISIONS OF GUISIE PERRY LIMITED

Performance Assessment and Management Advice:

  • Cruise Division: The Cruise Division is performing well with a high ROI and positive RI. Management should consider further investment and capital allocation to this division.
  • Ferry Division: The Ferry Division also has a good ROI and a positive RI, indicating satisfactory performance. Management should continue to monitor this division for potential growth opportunities.
  • Container Division: The Container Division has a lower ROI and a negative RI, suggesting underperformance. Management should evaluate the reasons for this and consider restructuring or cost reduction strategies.
  • Bulk Shipping Division: The Bulk Shipping Division is underperforming with both negative ROI and RI. Management should consider whether to divest or significantly restructure this division.

d) Porter’s Five Forces Analysis of the Cruise and Ferry Shipping Market:

  1. Threat of New Entrants: The cruise and ferry market requires significant capital investment, which can act as a barrier to entry. However, the potential for profitability in this growing market could attract new competitors.
  2. Bargaining Power of Suppliers: Suppliers have moderate power due to the need for specialized vessels and the limited number of shipbuilders capable of meeting specific requirements.
  3. Bargaining Power of Buyers: Buyers in the cruise industry, particularly holidaymakers, have a wide range of options. This gives them higher bargaining power, especially if service quality does not meet expectations.
  4. Threat of Substitutes: The threat of substitutes is low as there are limited alternatives to marine transport for the specific services provided by Gussie Perry Ltd.
  5. Industry Rivalry: Competition is moderate, with a few established players in the market. However, as new entrants and expansions occur, the rivalry could intensify.

 

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