Topic: Divisional Performance

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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.

  • 2 Marks

: MA – Dec 2023 – L2 – Q1b – Divisional Performance

This question defines the concept of responsibility accounting in management accounting systems.

Define the term responsibility accounting.

Responsibility accounting is a system of accounting that segregates revenue and costs into areas of personal responsibility to monitor and assess the performance of each part of an organisation.

  • 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.
  • 5 Marks

MA – Nov 2018 – L2 – Q1b – Divisional Performance

Evaluate the impact of scrapping an inefficient bus on the ROI of a transportation business unit.

Super Express Transport Company runs a fleet of buses on the Accra-Sunyani route, which is considered a business unit.

The following is an extract from the final accounts of the company as at the last operating year:

  • Stock of buses on that route at cost less depreciation is GH¢660,000.
  • Net operating profit is GH¢198,000.

One of the buses, bought three years ago at the cost of GH¢150,000, was not performing efficiently because it got involved in an accident just a year after it was purchased. Although the damage was minor, the Operations Manager suggested that the bus be scrapped, in spite of the fact that it earned a profit of GH¢6,000 in the year. Depreciation is at the rate of 20% p.a. on a straight-line basis.

Required:
Evaluate the effect of this proposal on the performance of the business unit, if Return on Investment (ROI) is used to measure the performance of subunits. (5 marks)

ROI without the proposal:

Profit/ Assets
GH¢198,000/ GH¢660,000
0.30 or 30%

ROI with the proposal:

GH¢192,000/600,000
0.32 or 32%

Decision:

The disposal will improve the unit’s performance.

  • 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%

  • 6 Marks

MA – April 2022 – L2 – Q1b – Divisional performance

Discuss the impact of involving managers in financial target setting and the disadvantages of using financial indicators alone for performance assessment.

The manager of the fitness club in Papase is dissatisfied with the quarterly bonus system and does not perceive it to be fair. He argues that the financial targets are based on a regional view of all Gyakie fitness clubs and do not take account of specific local circumstances. For instance, the fitness club in Papase is located in a less affluent area of the region. Managers also complain about using solely financial indicators in setting targets. The manager of the fitness club in Papase would like to see participation from all fitness club managers in the development of quarterly financial and non-financial targets.

Required:

i) Discuss the potential impact on Gyakie for involving the fitness club managers in the preparation of their quarterly financial targets. (3 marks)

ii) Explain THREE (3) disadvantages of using financial performance indicators alone to assess performance. (3 marks)

i) Impact of Manager Involvement:

The managers’ involvement with setting the quarterly financial target could mean that the target will be more accurate and realistic. This is because the managers will be close to the operations of the fitness clubs and will be able to use their specialist knowledge to advise on regional variations to targets. For example, a national assumption of an increase of 10% in average revenue per customer may not be appropriate for the fitness club at Papase and should not automatically be factored into target setting. This involvement of managers could result in more accurate forecast information that can be used by the finance team in devising the financial targets. However, it is possible that the input of the managers may result in unrealistic financial targets. The managers may attempt to influence the targets to attain a bonus more easily. The fitness club managers may also not have an overall picture of the fitness club market or Gyakie’s strategic outlook.

ii) Disadvantages of Using Financial Indicators Alone:

  • Short-termism: Linking rewards to financial performance may tempt managers to make decisions that will improve short-term financial performance but may have a negative impact on long-term profitability. For example, a manager may decide to delay investment in order to boost the short-term profits of their division.
  • Internal Focus: Financial performance measures tend to have an internal focus. In order to compete successfully, it is important that external factors (such as customer satisfaction and competitors’ actions) are also considered.
  • Manipulation of Results: In order to achieve target financial performance (and hence their reward), managers may be tempted to manipulate results. For example, the recording of the costs incurred in the current year may be deferred to the next year’s accounts in order to improve current year performance.

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