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IM19.7 Advanced: Discussion of residual income and ROI and the problems with using these measures. Indico Ltd is a well established company that 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 that are unrelated to each other and to the original business. Indico Ltd has organized the operation of its four activities on a divisional basis with four divisional general managers having overall responsibility 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 the year ending December. The total capital employed at mid-year amounted to $50 million, of which E20 million was debt capital financed at an average annual interest rate of 10 per cent. Head office assets comprise 50 per cent fixed assets and 50 per cent 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 cent per annum. No new investment was undertaken in during the year pending a review of the performance of each division. The results for the divisions for the year to 31 December are as follows: Division A B C (Em) (Em) D (Em) (Em) Sales 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 4.0 1.2 0.5 24Exceptional charge (2) (1.8 Profit(loss) after exceptional charges 4.0 1.1 (0.6) 0.5 Group interest charge (3) (1.1) (0.3) (0.2) (0.1) Net divisional profit(loss) 2.9 0.8 (0.8) 0.4 Depreciation charged above 3.0 1.0 2.0 0.4 Net assets (at year end) 23.5 9.5 4.0 1.8 1 The exchange gain represents the difference between the original sterling value of an overseas contract and the eventual receipts in sterling. The exceptional charge relates to the closure of a factory in January. Group interest is purely a notional charge from head office based on a percentage of sales. Requirements: (a) Calculate the return on investment and residual 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 performance 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) ICAEW P2 Management Accounting