Question

Convenient Food Markets (CFM) is a chain of more than 100 convenience stores. The company has faced increasing competition over the past several years, mainly because department store chains have been adding grocery departments and gas stations have been adding full-service convenience stores to their locations. As a consequence, the company has lost market share recently to competitors. The company has set a target minimum rate of return for its stores of 22%.

John Nicholson is the district manager of the 17 CFM stores in Bailingham. Nicholson’s district happens to include the original store, the first in the CFM chain, which opened more than 40 years ago. In fact, Nicholson’s first summer job was as a stock boy at the original store in the year that it opened. After university, he returned to CFM as a store manager, has worked his way up to district manager, and plans to retire in about five years.

CFM leases store buildings, investing significantly in the interior design, display, and decoration. The original CFM store remains profitable, in part because the fixtures and fittings are almost fully depreciated. While the company has invested in significant leasehold improvements in other newer stores, little has changed in the original store since opening day. While Nicholson has a sense of nostalgia for the original store, in reality, sales volumes have been falling and foot traffic has declined significantly in recent years. Fewer people are moving to the neighbourhood, as more and more people are moving to the suburbs.

All 17 stores in the district report to Nicholson, who is evaluated on the basis of average ROI for the stores in his district. For this calculation, the net book value of investment in furnishings and fixtures Page 504represents the operating assets of each of the stores. Operating income after depreciation on leasehold improvements represents the numerator for this calculation.

Nicholson is considering a proposal from a developer to open a new store in a newly developed residential neighbourhood. The developer has completed about 60% of the new homes planned for this neighbourhood and will complete the other 40% within the next 18 months. Due to limited capital to invest, Nicholson realizes that opening the new store would mean closing down an old store, and the original store seems to be the best candidate. To aid in his decision, Nicholson has collected the following information:

	Original Store (prior-year actual	New Store (forecast)
operating income less depreciation	$75,000	$145,000
net book value of operating assets	195,000	475,000

Required:

1.Calculate the ROI and residual income for both the original store and the new store.

2. Take on the role of an internal auditor at CFM. Assume that your task is to evaluate the effectiveness of the performance evaluation system for CFM district managers. In this capacity, write a short memo to the CFO of CFM to discuss your findings. In the memo, you should indicate whether you believe Nicholson will want to open the new store, whether your analysis indicates that Nicholson should open the new store, and why or why not. You should also include your observations about the effect of the performance evaluation system on the decisions made by CFM district managers and what might be done to improve it.

Answer 1

Answer to Question No. 1			(Amount in $)
Particulars	Reference	Original Store (prior-year actual	New Store (forecast)
operating income less depreciation	A	75,000	145,000
net book value of operating assets	B	195,000	475,000
ROI	C = A / B	38.46%	30.53%
Target Minimum Rate of Return	D	22%	22%
Residual Income	E = A - (B * D)	32,100	40,500

Answer to Question No. 2.

At present, John Nicholson is the district manager of the 17 CFM stores and he has invested almost entire time of his life working for these Original stores. He may not want to open new stores mainly due to following reasons:

1. Considering the fact that he has a plan to retire after 5 years
2. He has a sense of nostalgia for the original store
3. The original CFM store remains profitable
4. ROI for Original Store is at 38.46% which is more than 22% i.e. Target Minimum Rate of Return

Based on the analysis of the information provided in the question, even though ROI of Original Store is more as compared to ROI of new stores, Nicholson should open the new store mainly because of following reasons:

1. The original store remains profitable because the fixtures and fittings are almost fully depreciated
2. The company has lost market share recently to competitors since no major changes done in original stores
3. Sales volumes at Original Stores have been falling and foot traffic has declined significantly in recent years.
4. Significant population is moving to the suburbs (newly developed residential neighborhood.)
5. Targeting large population located in newly developed residential neighborhood by opening new stores will definitely result in increase in ROI in future, increase in market share.
6. Residual income under option of new stores is higher as compared to continuing with Original stores.

Evaluating performance of Store manager based on formula of ROI is not justifiable mainly because:

1. In order to increase operating income, store manager needs to incur some additional capital expenditure to make it more attractive to customers and to be competitive with rivals.
2. Stores manager may be reluctant to incur cost for investment in furniture and fixtures which eventually results in reduction in ROI at initial stages.
3. Other parameters like increase in sales, reduction in operating cost, etc. may be considered for evaluation for performance of store manager.