Advanced: Calculations of residual income using straight line and annuity depreciation

(a) Meldo Division is part of a vertically inte¬ grated group where all divisions sell exter¬ nally and transfer goods to other divisions within the group. Meldo Division manage¬ ment performance is measured using control¬ lable profit before tax as the performance measurement criterion.

(i) Show the cost and revenue elements which should be included in the calcula¬ tion of controllable divisional profit before tax. (3 marks)

(ii) Discuss ways in which the degree of autonomy allowed to Meldo Division may affect the absolute value of control¬ lable profit reported. (9 marks)

(b) Kitbul Division management performance is measured using controllable residual income as the performance criterion.

Explain why the management of Kitbul Division may make a different decision about an additional investment opportunity where residual income is measured using:

(i) straight-line depreciation or

(ii) annuity depreciation based on the cost of capital rate of the division.

Use the following investment information to illustrate your answer:

Investment of £900 000 with a three year life and nil residual value.

Net cash inflow each year of £380000.

Cost of capital is 10%. Imputed interest is calculated on the written-down value of the investment at the start of each year.

Present value of an annuity of £1 for three years at 10% interest is £2.487. (8 marks)

(Total 20 marks) ACCA Level 2 Cost Accounting II