Advanced: Impact of transactions on divisional performance measures and various issues relating to divisional performance measurement Scenario Frantisek Precision Engineering pic (FPE) is an engineering company which makes tools and equipment for a wide range of applications. FPE has twelve operating divisions, each of which is responsible for a particular product group. In the past, divisional performance has been assessed on the basis of Residual Income (RI). RI is calculated by making a finance charge (at bank base rate + 2%) on net assets (excluding cash) as at the end of the year to each division.

Rapier Management Consultants have recently been engaged to review the management account¬ ing systems of FPE. In regard to the performance evaluation system, Rapier have reported as follows:

RI is a very partial and imperfect performance indicator. What you need is a more comprehen¬ sive system which reflects the mission, strategy and technology of each individual division. Further, executives should each be paid a per¬ formance bonus linked to an indicator which relates to their own personal effectiveness.

FPE’s Directors provisionally accepted the Rapier recommendation and have carried out a pilot scheme in the diving equipment (DE) division. DE division manufactures assorted equipment used by sport and industrial divers. Safety is a critical factor in this sector. Customers will not readily accept new products, design features and technologies, and therefore many remain unexploited.

At the start of 2000, Rapier designed a per¬ formance evaluation system for DE division as follows:

DE division’s accounting office currently consists of four employees. The division does not have its own bank account. All main accounting systems are operated by FPE’s Head Office. DE’s account¬ ing staff draw information from the main account¬ ing system in order to prepare weekly budgetary control reports which are submitted to Head Office. The reports prompt regular visits by Head Office accountants to investigate reported cost variances.
Part One In November 2000, DE’s Accountant predicts that DE’s results for 2000 will be as follows:

The Accountant further forecasts that in the absence of some change in policy or new invest¬ ment, the corresponding figures for 2001 and end- 2001 will be similar to those shown above for 2000. Upon receiving this forecast, DE division’s Chief Executive convenes a meeting of his managers to discuss strategy for the rest of 2000 and for 2001. Several proposals are made, includ¬ ing:
From the Office Manager:
I propose that we immediately dispose of £160000 of stock at cost and defer a creditor payment of £180000 due 16 December 2000 until 2 January 2001. The first measure will reduce profit by £16 500 a year from 2001 onwards. The second measure will incur an immediate £2000 penalty.
From the Production Manager:
I recommend we invest £400 000 in new equip¬ ment, either immediately or in early 2001. This will increase operation profit by £25 000 per year for eight years and the equipment will have a residual value of £40 000 at the end of its life.
From the Design Manager:
I propose we introduce a new electronic digital depth gauge to the market. This will involve an initial investment of £100000 in new equip¬ ment, either immediately or in early 2001, which will have a life of at least ten years. Sales will have to be on 6 months’ ‘buy or return’ credit in order to overcome market resistance. I forecast that the new depth gauge will generate £20 000 extra operating profit per year with purchases, sales, stock and creditors all increasing in proportion.
Requirements:

(a) Explain the impact of each proposal on the reported performance of DE division in 2000 and 2001, having regard to the new perfor¬ mance evaluation criteria stated in the Scenario.
State whether or not each proposal is likely to be acceptable to members ofDE management.
(15 marks)

(b) State your views (supported by financial evaluation) on the inherent merits of each proposal, having regard to factors you consider relevant. (10 marks)
Note: Where relevant, you may assume that depre¬ ciation is on a straight-line basis and DCF evalu¬ ation is carried out using an 8% discount rate and 10-year time horizon.
Part Two A great deal of management accounting practice (including divisional performance evaluation) can be carried out with varying degrees of sophistication. Many new techniques have been developed in recent years. The degree of sophistication adopted in any case is partly influenced by the imagination and knowledge of the management accountant, and partly by the availability of management information technology.
Requirements:

(a) In the light of this quotation, state your views on the advantages and disadvantages to FPE of using a firm of consultants to advise on the design of management accounting systems. Explain your opinion on the merits of the statement quoted above. (10 marks)

(b) Explain the main purpose of divisional organ¬
isation and the main features of the manage¬ ment accounting systems that are used to support it. (5 marks)

(c) Explain the changes that might be required in the management accounting operation of DE division if that division became an indepen¬ dent business. (10 marks)
Part Three There is nothing inherently wrong with the factors used in DE’s new performance evalu¬ ation system. The problem is what those factors are used for - in particular, their use as a basis for management remuneration. For one thing, almost any factor is highly vulnerable to manip¬ ulation: for another thing, they can seriously distort business decision making.
Requirements:
Having regard to this statement,

(a) explain the strengths and weaknesses of RI and ROCE as divisional business performance indicators as far as FPE is concerned;
(5 marks)

(b) comment critically on the statement made by Rapier (quoted in the Scenario). In particular, explain the problems connected with linking management pay to performance, and the measures that management accountants might take to deal with these problems;
(7 marks)

(c) explain what JIT philosophy is, in the light of a proposal to adopt just-in-time (JIT) practices in the DE division. Write a report for FPE management on whether or not DE division’s Production Manager should be paid a bonus linked to CCP instead of one linked to ROCE (see Scenario), in the light of the proposal to adopt JIT practices in the DE division.

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Factor Return on Capital Employed (ROCE) Cash conversion period (CCP) Strategy Calculated Operating profit for the year divided by book value of net assets (excluding cash) at the end of the year. Number of days' debtors plus days' stock minus days' creditors outstanding at the end of the year. Number of new products and major design features (innovations) successfully brought to market.