Question

Divisions X and Y are two divisions of a large, manufacturing company. Whilst both divisions operate in almost identical markets, each division operates separately as an investment centre.

Each year, operating statements must be prepared by each division and these are used as a basis for performance measurement for the divisions. Last year, senior management decided to recharge head office costs to the divisions. Consequently, each division is now going to be required to deduct a share of head office costs in its operating statement before arriving at ‘net profit’, which is then used to calculate return on investment (ROI). Prior to this, ROI has been calculated using controllable profit only.

The company’s target ROI, however, remains unchanged at 20% per annum. For each of the last three years, Divisions X and Y have maintained ROIs of 22% per annum and 23% per annum respectively, resulting in healthy bonuses being awarded to staff. The company has a cost of capital of 10%.

The budgeted operating statement for next year is shown below:

                                      Division X                           Division Y

                                          £’000                                 £’000

Sales                                1,300                                  1,500

Less variable cost              (700)                                  (800)

Contribution margin            600                                     700

Lesscontrollable fixed costs (134)                                 (228)

Controllable profit                  466                                    472

Less apportionment of

head office costs                  (155)                                  (180)

Net profit                                 311                                      292

Divisional net assets 2,320 2,260 

Required: Calculate the expected Return on Investment (ROI) using the new method as preferred by senior management, based on the above budgeted operating statements, for each of the divisions.

The divisional managing directors are unhappy about the results produced by your calculations in (a) and have heard that a performance measured called ‘residual income’ may provide more information. Calculate the residual income (RI) for each of the divisions, based on the net profit figures for the next year. 

Discuss the expected performance of each of the two divisions using both ROI and, RI, and making any additional calculations deemed necessary. Conclude as to whether, in your opinion, the two divisions have performed well

Answer 1

Computation of Return On Investmet (ROI)

ROI= Net Profit/ Net asset x 100

 

	Division X	Division Y
	£’000	£’000
Net asset	2,320	2,260
Net Profit	311	292
ROI	13.41%	12.92%
	[311/2,320x100]	[292/2,260x100]

Computation Of Residual Income

Residual Income= (Net Asset x Cost of Capital)- Net Profit

	Division X	Division Y
	£’000	£’000
Net asset (i)	2,320	2,260
Cost of Capital (ii)	10%	10%
Expected Profit (iii)=(i) x(ii)	232.00	226.00
Actual Net Profit (iv)	311	292
Residual Income (iv)-(iii)	79.00	66.00

While considering Residual income approach division X has higher RI than Division Y 

More Investment in Division X result in higher profit to the business as whole

 

ROI= Division -X- 13.41%

ROI= Division Y- 12.92%

Residual Income- X -79,000

Residual Income- Y-66,000