Question

Luxury Ltd is a large company that manufactures and sells wooden garden furniture. It has been very active in acquisition in recent years and acquired three small companies in the last few years. Mr. Yung, the CEO, determines to let the three companies running as autonomous investment center, as Division A, B and C respectively, each responsible for different specific product groups. The most recent sales and operating data for the three divisions are given below (In million dollars):

	Operating Income		Sales		Average Assets
Division	2018	2019	2018	2019	2018	2019
A	$9.20	$11.30	$45.50	$46.30	$44.40	$49.10
B	3.40	3.80	60.00	64.00	27.20	30.10
C	2.30	2.50	15.00	15.50	25.00	26.00

Managers are given as much freedom as possible to manage their divisions. Division managers have an annual bonus plan based on division Return on Investment (ROI). Senior executives of divisions reporting increases in ROI from the prior year are automatically eligible for a bonus.

Peter, manager of Division A, is considering a proposal to invest $2 million in asset to produce a new product that would generate a $0.29 million operating income. Mary, manager of Division C, is considering a proposal to invest $1 million in asset to produce a new product that would generates a $0.11 million operating income. The company has a 12% minimum required rate of return in all three divisions.

Required:

a. Calculate the margin, turnover, ROI for the three division for 2018 and 2019. Explain the trend over time and differences among the three divisions in their ROIs.

b. Who will accept the proposal? Show your supporting calculations for each division if they accept the investment opportunity based on the results in 2019.

c. Mr. Yung receives a suggestion to base senior executives’ compensation at each division on division Residual Income (RI). Calculate the RI of each division in 2019 (before proposal.) Which division’s manager might object to the change?

d. With a change in the bonus plan based on RI, who will accept the proposal? Show your supporting calculations for each division if they accept the investment opportunity.

e. Mr. Yung has heard of the concept of balanced scorecard. He is wondering why does the balanced scorecard include financial performance measures as well as measures of how well internal business processes are doing? Explain to him in detail.

Answer 1

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Luxury Ltd				Note
Answer a	Division A	Division B	Division C
For 2018
Operating Income	9.20	3.40	2.30	A
Sales	45.50	60.00	15.00	B
Margin	20.22%	5.67%	15.33%	C=A/B
Sales	45.50	60.00	15.00	See B
Average Assets	44.40	27.20	25.00	D
Turnover	1.02	2.21	0.60	E=B/D
Operating Income	9.20	3.40	2.30	See A
Average Assets	44.40	27.20	25.00	See D
Return on investment	20.72%	12.50%	9.20%	F=A/D
For 2019
Operating Income	11.30	3.80	2.50	G
Sales	46.30	64.00	15.50	H
Margin	24.41%	5.94%	16.13%	I=G/H
Sales	46.30	64.00	15.50	See H
Average Assets	49.10	30.10	26.00	J
Turnover	0.94	2.13	0.60	K=H/J
Operating Income	11.30	3.80	2.50	See G
Average Assets	49.10	30.10	26.00	See J
Return on investment	23.01%	12.62%	9.62%	L=G/J
Answer b	Division A		Division C
Operating Income	0.29		0.11	M
Average Assets	2.00		1.00	N
Return on investment	14.50%		11.00%	O=M/N

The ROI of new project is more in Division C, so if ROI is criteria for bonus then Division C will accept the project.

Answer c	Division A	Division B	Division C
Average Assets	49.10	30.10	26.00	P
Required rate of return	12.00%	12.00%	12.00%	Q
Target return	5.89	3.61	3.12	R=P*Q
Operating Income	11.30	3.80	2.50	See G
Residual Income	5.41	0.19	(0.62)	S=G-R

Division C might object to the change as its RI is negative so it will not be eligible for bonus.

Answer d	Division A		Division C
Average Assets	2.00		1.00	See N
Required rate of return	12.00%		12.00%	See Q
Target return	0.24		0.12	T=M*Q
Operating Income	0.29		0.11	See M
Residual Income	0.05		(0.01)	U=M-T

The RI of new project is negative in Division C, So Division C will not accept but The RI of new project is positive in Division A, So Division A will accept.

Answer e

A company's balance scorecard is put together to support their strategy and is used to widen and strengthen company’s goals. Both financial and internal business processes are included to fully understand how a business is performing and what their strategy is.