Question

Perry plc is a large conglomerate company structured on a divisional basis. It seeks to maximise investor wealth. Head office avoids day to day involvement in divisional affairs and only intervenes if performance is considered unsatisfactory. Divisional performance is measured by residual income.

One of Perry’s larger divisions operates a chain of high-class hotels throughout the United Kingdom. The division’s mission statement is ‘To be the hotel of the first choice for business users and tourists’. Although the chain has generally been popular with tourists it is not proving quite so popular with business users and conference organisers. Competition in the top segment of the hotel market is fierce, with customers expecting the highest standards of facilities, service, and catering. Over the last two years, the division has invested a large amount of money in modernising its hotels including the improvement of bedrooms and public rooms, installation of gymnasia and swimming pools and the information technology features required by business travelers. A large amount of money has also been spent on staff training to improve service levels and on a television advertising campaign to promote improved hotels to business users.

Head office is concerned that the performance of the hotel chain appears to have declined over the last few years despite this expenditure.

         The following figures are available

	$ millions	$ millions	$ millions
	2016	2017	2018
Capital employed	50	70	90
Operating profit	15	16	17

The cost of capital applicable to the hotel division is 20% per annum

Required:

1. Calculate the residual income for the hotel chain for each of the three years.
2. Discuss three advantages and four disadvantages of residual income as a divisional performance measure.                                                                                                     ( 7 marks)

Answer 1

a

Calculation of residual income-Figure in Millions

RI = Operating Income - (Operating Assets x Target Rate of Return)

2016

2017

2018

Capital Employed

50

70

90

Operating Profit

15

16

17

Cost of capital

20%

20%

20%

RI

15-(50*20%)

16-(70*20%)

17-(90*20%)

15-10

16-14

17-18

5

2

-1

b

Advantages of RI as divisional performance

*It is an absolute measure of measuring divisional performance

*Achieve Goal Congruence-It is said that the probability that managers will be

encouraged when acting in their best interest and to act in the best interest of the division like operating the high chain of hotels in Perry's divisions

*RI will increase when investments earnings above the COC are undertaken and investments earnings below the cost of capital

are eliminated for divisional performance in the above case in Perry's division.

Disadvantages of RI as divisional performance

*Accounting performance measure-RI is accounting performance measure and accounting profit can easily be manipulated by

adopting different accounting policies and procedures.Since it is subject to management biased therefore cannot be considered a good

measuring tool.

*Size Influences-RI is greatly influenced by size of the Capital Employed.Therefore it cannot be used to compare

the performance of investment center with different size.larger investment center will always show the improve

performance than other investment center.

*Difficult to understand-RI method is difficult to understand and apply.This method cannot be easily applied and require

a deep accounting and financial management knowledge.

*Imputed Interest Rate Decision-Imputed interest rate requires a lot of expert knowledge and based on different

rates available the management have to decide to use one of them as interest rate.