Question

Y and Z are two divisions of a large company that operate in similar markets. Division Y represents the original manufacturing trade of the business but Division Z is a relatively new service/maintenance business and has seen considerable growth in its first two years of operation. The divisions are treated as investment centres and every month they each prepare an operating statement to be submitted to the parent company. Operating statements for these two divisions for October are shown below:

Operating statements for October

	Y	Z
	$000	$000
Sales revenue	900	555
Less variable costs	345	312
Contribution	555	243
Less controllable fixed costs (includes depreciation on divisional assets)	98	42
Controllable income	460	201
Less apportioned central costs	338	180
Net income before tax	122	21
Total divisional net assets	$9.76m	$1.26m

The company currently has a target return on capital of 12% per annum. However, the company believes its cost of capital is likely to rise and is considering increasing the target return on capital. At present the performance of each division and the divisional management are assessed primarily based on Return on Investment (ROI).

Required:

(a) Calclate the annualised Return on Investment (ROI) for divisions Y and Z, and discuss the relative performance of the two divisions using the ROI data and other information given above.

(b) Calculate the annualised Residual Income (RI) for divisions Y and Z, and explain the implications of this information for the evaluation of the divisions' performance.

Answer 1

Please hit LIKE button if this helped. For any further explanation, please put your query in comment, will get back to you.

1.
		millions	millions
	ROI	Y	Z
A	Monthly Net Income	0.122	0.021
B=A*12	Annualized Net Income	1.464	0.252
C	Divisional Net Assets	9.76	1.26
D=B/C	ROI	15%	20%
	Z is performing better than Y on the basis of ROI
	Y earning is way higher than Z, also exceeding target return of capital. Meaning increasing company wealth higher than Z which is not reflected in ROI
	If Target Return is to be raised, Y is at greater risk as it is closer to existing Target return
	Net Income figure are strongly influenced by Apportioned cost which needs to be investigated
2.
		millions	millions
	RI	Y	Z
A	Annualized Net Income	1.464	0.252
B	Divisional Net Assets	9.76	1.26
C=B*12%	Interest Charged @12%	1.171	0.151
A-C	RI	0.293	0.101
	If capital is freely available then the higher RI indicates the division that is contributing most to the company as a whole.
	Thus division Y is contributing more. This is the opposite conclusion to that indicated by ROI
	Overall the issue is that Y earns more income, but Z earns its income at a better rate