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  • 5 Marks

MA – Mar 2024 – L2 – Q1b – Divisional performance | Discounted Cash Flow

This question explains why the divisional manager may reject an option with a higher NPV and discusses board acceptability.

The performance bonus of the fragrance divisional manager is linked to Return on Investment (ROI) and Residual Income (RI) and has an impact on the calculation of retirement benefits. The manager is due to retire at the beginning of Year 3.

Required:
Explain why the fragrance Divisional Manager will not invest in the option showing the higher NPV and comment on whether it will be acceptable to the Board

The fragrance Divisional Manager is likely to favor Option 2, despite its lower NPV, because it yields a higher ROI and RI during the first two years. Since the manager is due to retire at the beginning of Year 3, their decision will be influenced by short-term personal interests, specifically maximizing their performance bonus and retirement benefits, which are based on ROI and RI in the first two years.

Board Perspective:
From the board’s perspective, the focus is on the long-term financial health and value creation for the company. The board would likely reject Option 2 because it underperforms in the later years and results in lower overall NPV, which does not align with the company’s objective of achieving sustainable returns exceeding 16%. Option 1, with its higher NPV, would be the better long-term choice for the company despite its lower short-term performance.

  • 10 Marks

MA – Mar 2024 – L2 – Q1a – Divisional performance

This question requires calculating ROI and RI for two investment options and choosing the best based on these performance metrics.

The Board of Otmost Beauty Ltd, a beauty care production company, is planning to introduce a new product. The Board has tasked the Divisional Manager of the fragrance division to evaluate two options to buy a production plant. Both options will have the same capacity and expected life of four years, but they will differ in capital costs and expected net cash flows as shown in the table below:

Option Option 1 (GH¢ million) Option 2 (GH¢ million)
Initial capital investment year 0 640 520
Net cash flows (before tax)
Year 1 240 260
Year 2 240 220
Year 3 240 150
Year 4 240 100
Net present value at 16% p.a 31.6 19.0

All divisions of the company are expected to generate pre-tax returns on divisional investments in excess of 16% per annum, which the fragrance division currently is just managing to achieve. Anything less than 16% would make the divisional managers ineligible for the annual performance bonus.

The performance bonus is linked to Return on Investment (ROI) and Residual Income (RI) and also has an impact on the calculation of retirement benefits, as the retirement benefits take into consideration the performance bonus earned during the two preceding years. The manager of the fragrance division is due to retire at the beginning of Year 3.

In calculating divisional returns, divisional assets are valued at the net book values at the beginning of the year. Depreciation is charged on a straight line basis with nil residual value.

Required:
i) Calculate the ROI and RI for years 1 to 4 and select the best option from the point of view of the fragrance division based on ROI and RI criteria.

i) Computation of ROI and RI for Option 1:

Year NBV at Beginning (GH¢m) Net Cash Flows (GH¢m) Depreciation (GH¢m) Profit (GH¢m) Imputed Interest @16% (GH¢m) Residual Income (GH¢m) ROI (%)
1 640 240 160 80 102.4 (22.4) 12.5%
2 480 240 160 80 76.8 3.2 16.7%
3 320 240 160 80 51.2 28.8 25.0%
4 160 240 160 80 25.6 54.4 50.0%

Computation of ROI and RI for Option 2:

Year NBV at Beginning (GH¢m) Net Cash Flows (GH¢m) Depreciation (GH¢m) Profit (GH¢m) Imputed Interest @16% (GH¢m) Residual Income (GH¢m) ROI (%)
1 520 260 130 130 83.2 46.8 25.0%
2 390 220 130 90 62.4 27.6 23.1%
3 260 150 130 20 41.6 (21.6) 7.7%
4 130 100 130 (30) 20.8 (50.8) (23.1%)

Conclusion:
Over the entire life of the project, both ROI and RI favor Option 1, with an average ROI of 26.05% and a cumulative RI of GH¢16 million, while Option 2 has an average ROI of 8.18% and a cumulative RI of GH¢0.5 million. Therefore, Option 1 is the best option based on both ROI and RI criteria.

  • 20 Marks

MA – July 2023 – L2 – Q1 – Performance analysis

This question involves explaining the controllability principle, calculating controllable profit, ROI, and RI, and analyzing the performance of two divisions.

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.

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:

  1. 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)

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