Advanced: Discussion of residual income and ROI and the problems with using these measures to evaluate a speculative new division operating in a high technology industry Indico Ltd is a well established company which has operated in a sound but static market for many years where it has been the dominant supplier. Over the past three years it has diversified into three new product areas which are unrelated to each other and to the original business.

Indico Ltd has organised the operation of its four activities on a divisional basis with four divisional general managers having overall respon¬ sibility for all aspects of running each business except for finance. All finance is provided centrally with routine accounting and cash management, including invoicing, debt collection and bill payments, being handled by the Head Office. Head Office operating costs were £1 million in 2000. The total capital employed at mid-2000 amounted to £50 million, of which £20 million was debt capital financed at an average annual interest rate of 10%. Head Office assets comprise 50% fixed assets and 50% working capital. To date, the company has financed its expansion without raising additional equity capital, but it may soon require to do so if further expansion is undertaken. It has estimated that the cost of new equity capital would be 20% per annum. No new investment was undertaken in 2000 pending a review of the performance of each division.

The results for the divisions for the year to 31 December 2000 are as follows:

Requirements

(a) Calculate the return on investment and resid¬ ual income for each division, ignoring the Head Office costs and stating any assumptions you consider appropriate. Explain how this information is useful in evaluating divisional performance, and outline the main standards of comparison you would use. (13 marks)

(b) Explain how you would deal with the Head Office costs in measuring divisional perfor¬ mance within Indico Ltd. (4 marks)

(c) Discuss the problems arising from using return on investment and residual income to evaluate a speculative new division operating in a high technology industry. State how you could improve these measures to enable better divisional comparisons to be made.
(8 marks) (Total 25 marks) ICAEW P2 Management Accounting

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Sales Division A B C D (m) (m) (m) (m) 110.0 31.0 18.0 13.0 Trading profit 2.0 1.1 1.2 0.5 Exchange gain (1) 2.0 - - Profit after currency movement Exceptional charge (2) 4.0 1.1 1.2 0.5 (1.8) - Profit/(loss) after 4.0 1.1 (0.6) 0.5 exceptional charges Group interest (1.1) (0.3) (0.2) (0.1) charge (3) Net divisional profit/(loss) 2.9 0.8 (0.8) 0.4