Question 2 (24 marks)

Khomas Beverages Ltd (KB) is a company that manufactures and sells beverages. The company is divisionalised such that the Windhoek division manufactures soft drinks while the Okahandja Division manufactures bottled water. Managers heading each of the two divisions have been empowered to make capital investment decisions of their divisions without head office interference.

KB measures the performance of the two divisions based on return on investment (ROI). When the division performs higher than the set ROI of 18%, the divisional managers will be given a performance bonus. In 2019, the Okahandja division rejected an investment that had a ROI of 18% for the reason that it would have diluted their overall ROI to 17.5%. This meant that the division would not have qualified for a performance bonus. When the Head Office of KB learnt of this bad practice, they were unhappy and have now decided to change how they measure performance by introducing the residual income (RI) approach. Both performance measures are based on the divisions controllable profit and the average assets of the division.

The following summarised operating statement has been prepared by an inexperienced accountant and you have been hired to assist her:

	Windhoek	Okahandja
	N$000	N$000
Sales revenue	3 800	8 400
Less Variable costs	(1 400)	(3 030)
Contribution	2 400	5 370
Less Fixed costs	(945)	(1 420)
Operating profit	1 455	3 950
Beginning controllable net assets per division	13 000	24 000
Ending controllable net assets per division	9 000	30 000

Notes:

1. Depreciation charge for the two divisions was N$165 000 for Windhoek and N$460 000 for Okahandja. The depreciation charge has already been included in the fixed costs contained in above operating statement. On further investigation, you have ascertained that 30% of the depreciation charge in both divisions relates to those assets that are controlled by the Head Office but are owned by the individual divisions.
2. Included in the net assets figures above is a plant acquired at the beginning of the year by the Okahandja division for a cost of N$2 million. The Okahandja division applies the reducing balance method of depreciation while the Windhoek applies the straight-line method. It is company policy to charge the full years depreciation in the year of acquisition. The Windhoek division did not add any significant amount to its noncurrent assets for the current period.
3. The Head Office costs allocated to each division in the period were N$620 000 for Windhoek and N$700 000 for Okahandja. These cost are included in the fixed costs shown in operating statement above.
4. The weighted average cost of capital (WACC) applicable to KB is 12%.

Requirement		Mark
2.1	Based on the current performance measure (i.e. ROI) determine the performance of the two divisions of KB for the current year.	8
2.2	Basing your answer on calculations in (2.1) above, identify the division that performed better than the other.	2
2.3	Highlight other factors that you consider important in interpreting the results of the two divisions (based on ROI) and discuss any relevant advice you would give to KB.	4
2.4	Using the proposed performance measure (i.e. RI) determine the performance of the two divisions of KB.	4
2.5	What conclusions can you come up with following your calculations in (2.4) above?	2
2.6	Discuss any two advantages that might accrue to KB of using the residual income as a performance measure.	2
2.7	Discuss any two draw backs that KB should be aware of as they plan to implement the residual income as a performance measure.	2
N.B. Where necessary show all relevant workings
Total		24