Question

Apple Corporation is structured into three divisions: Austin, Brown and Caden. Each division operates as a separate stand-alone business, and is designated as an investment centre. The company uses return on investment (ROI) to evaluate the performance of each division. For the purpose of calculating divisional ROI, invested capital is defined as total assets (net book value) less current liabilities, and divisional operating profits after tax are used. Each division is required to achieve an ROI of at least 9%.

The following data relates to the financial performance of the divisions for the year of 2019:

	Austin	Brown	Caden
Operating Profits	$1,000	$900	$1,200
Total Assets (NBV)	18,000	4,000	36,000
Current Liabilities	8,000	1,000	11,000
ROI	10%	30%	4.8%

Both Austin and Brown mainly operate education centers with focus on conducting computer and IT courses. Major assets of Austin Division include computer equipment, popular software and furniture and fixtures. All these assets have been used since the business was set up in 2016. No additional purchase of new assets was made.

Although Brown operates in a similar business, it has different operational philosophy. Brown leases its computer equipment and software in order to have the most updated IT facilities for their customers. Therefore, the lease (rental) expenses account for a high percentage of its total operating expenses.

Caden runs two restaurants which were newly set in 2019. The target customers are the highclass clusters. Therefore, high amount was spent on decent and splendid furniture and decoration.

Based on the ROI calculation, the management would rank Brown as the top performer while Caden is required to put significant effort to improve its performance.

REQUIRED:

1) Suggest TWO points in the case that needs to be taken into account when interpreting divisional performance by using ROI.

2) State and explain any action for Austin and Caden Division to improve their ROIs but it will result in UNDERSIRABLE operating results (ONE action for each Division).

3) Suggest TWO ways to minimize the negative behavioral effects of ROI (use examples in your answer.

Answer 1

1. ROI = Operating Profit / Total Assets.

The first point to be considered is that, Brown leases its assets, therefore, the denominator is very low compared to Austin. This explains the higher ROI for brown despite lower operating profits. Secondly, Brown has high operating leverage ( high fixed lease expenses), as a result of which its operating profits are lower as compared to Austin.

Since operating leverage of Brown division is higher, the operating risk too is higher, which implies that a downturn in sales could lead its ROI to dip by a higher percentage as compared to Austin.

Caden has been set up very recently, with large investments in fixed assets, and therefore, in the initial years, sales would be low, and depreciation expense would be high. Therefore, in spite of having the highest operating profit, it has the lowest ROI because of the highest investment in assets.

2. Austin should try to increase sales volume and sales price.

Caden should switch to an accelerated depreciation ( double declining) method from straight-line method, so that its NBV gets reduced faster, thereby improving its ROI.

3. Residual income might be used for evaluating managerial performance rather than ROI.