Question

luton homes is a leading builder of luxury houses. Three years ago, luton expanded its business by acquiring clarity homes, which gave luton a significant presence in the project home market. Clarity is managed as an investment centre and Roi is used to assess clarity performance9with the average of begining and end of a year investment balances being used to in the roi calculations). Bonuses for the clarity manager are also based in part on Roi.

Investment made by lutton homes and its clarity division are expected to earn a minimum required rate of return of 12% before income tax. The result from last years operation at clarity is provided below.The division productive assets were $682500 at the year end a 5% increase over the prior year end balance.

sales revenues $1000000

variable expenses 300000

contribution margin 700000

Fixed expense 500000

net operating income 200000

This year the company has a $190000 investment opportunity with the following cost and revenue charactertics

sales revenues $200000

contribution margin ratio 60% of sales

Fixed expense $90000

q3.1

What is the likely reaction of clarity division managers towards the investment opportunity? Would the ceo of luton homes want him to pursue the investment opportunity? Explain your answers with supporting evidence around 100 words

q3.1.2

Assume that luton homes uses residual income to evaluate claritys performance. Will the manager of the Clarity division be likely to change its attitude towards the investment opportunity? would using residual income help soving goal congruence here? explain your answer with supporting evidence

Answer 1

q3.1 Clarity Division is not likely going to invest in the new investment oppurtunity if ROI is used to measure its performance . Clarity division has an ROI of 30% whereas The new project has an ROI of only 16%.

Hence, it will not invest in the new project as it will also affect in the decline of the Clarity Manager's  bonus .

Calculations are shown below

However CEO of Luton would want him to pursue the investment oppurtunity as the Luton's (Company as a whole) expected rate of return is only 12% whereas the new project holds an ROI of 16 % ,which is 4% extra.

q3.1.2

If residual Income is used to assess the investment, Clarity division manager is most likely willing to invest in the new investment oppurtunity because the investment generates extra earnings.

A project with positive RI(residual income) will be accepted even if it will reduce overall or Divison ROI.

Calculations are shown below

Note : % used in the calculation is required rate of return that managemnet has set.

Target amount is usually some % of rate of return on total employed assets of the division or the invested capital of the division .

Yes, Using residual income will help solving goal congruence here. Goal Congruence is aligning of goals of the individual managers with the goals of the organisation as a whole. It means that the individuals & organisations segment are all working towards achieving the organisation goals.