Question 5. ROI and RI

The Biscuits division (Division B) and the Cakes division (Division C) are two divisions of a large, manufacturing company. Whilst both divisions operate in almost identical markets, each division operates separately as an investment center. Each month, operating statements must be prepared by each division and these are used as a basis for performance measurement for the divisions.

Last month, senior management decided to recharge head office costs to the divisions. Consequently, each division is now going to be required to deduct a share of head office costs in its operating statement before arriving at net profit, which is then used to calculate return on investment (ROI). Prior to this, ROI has been calculated using controllable profit only. The companys target ROI, however, remains unchanged at 20% per annul. For each of the last three months, Divisions B and C have maintained ROIs of 22% per annul and 23% per annul respectively, resulting in healthy bonuses being awarded to staff. The company has a cost of capital of 10%.

The budgeted operating statement for the month of July is shown below:

	B	C
	$000	$000
Sales revenue	1,300	1,500
Less variable costs	(700)	(800)
Contribution	600	700
Less controllable fixed costs	(134)	(228)
Controllable profit	466	472
Less apportionment of head office costs	(155)	(180)
Net profit	311	292
Divisional net assets	$23.2m	$22.6m

Required:

1. Calculate the expected annualized Return on Investment (ROI) using the new method as preferred by senior management, based on the above budgeted operating statements, for each of the divisions.
2. The divisional managing directors are unhappy about the results produced by your calculations in (a) and have heard that a performance measure called residual income may provide more information. Calculate the annualized residual income (RI) for each of the divisions, based on the net profit figures for the month of July.
3. Discuss the expected performance of each of the two divisions, using both ROI and RI, and making any additional calculations deemed necessary. Conclude as to whether, in your opinion, the two divisions have performed well.
4. Discuss the expected performance of each of the two divisions By Using controllable profit, both divisions seem to have improved their performance.
5. Could the positive RI be as a result of the cost of capital being lower than the Groups target return on investment (i.e. 10%<20%) leading to the positive RI?