Question

LUSAKA Plc has two divisions, GAMMA and OMEGA, whose respective performances are under review. Division GAMMA is currently earning a profit of K35,000 and has net assets of K150,000. Division OMEGA currently earns a profit of K70,000 with net assets of K325,000.

LUSAKA Plc has a current cost of capital of 15%.

Required:

(a) Explain the difference between a profit centre and an investment centre of an organisation. [3 Marks]

(b) Using the information above, calculate the return on investment and residual income figures for the two divisions under review and comment on your results. [5 Marks]

(c) Explain which method of performance evaluation (i.e. return on investment or residual income) is more useful when comparing divisional performance. [2 Marks]

Answer 1

The key difference between the investment center and cost center is that cost center is responsible only for the revenue and cost related decision. Profit making is the motive of that cost center with the limited resources what it have currently.

However the main motive of the investment center is to look after all the aspects like the cost, revenue , & profit . Together with that it also has to focus on the growth of the unit as in … what investment is to be made in forms of purchase of assets or any other investment which would help the center to achieve even more profit with currently what it is earning.

	GAMMA(amount in $)	OMEGA(amount in $)	remarks
PROFIT	35000	70000
NET ASSETS	150000	325000
COST OF CAPITAL	15%
Return on investment	23.33	21.54	(profit/investment *100)
Residual income	12500	21250	(profit -cost of capital*investment)

Comment:

ROI is a method which measure how much return is earned by the company on investing any specified amount. With the help of ROI, the company can compare the effectiveness and profitability of the center. However the residual income measures the net income which any investment can earn beyond the lowest return on its investment.

In the given situation ,

Division GAMMA has earned higher rate of investment when compared with Omega division however , the residual income is less as compared to Omega division which depicts that Though GAMMA division is earning more return on investment but potential of Omega division for growth and earning is more as compare to GAMMA division.

c. For comparing the divisional performance, Residual income method is more useful as it help management to understand the efficiency of the investment made. However the ROI helps the management much in taking new business opportunities or decision making.

And in the given situation , division OMEGA has more residual income as compared to GAMMA division.