Wholly Grains Group is a divisionalised group of companies. Among its divisions are Grain and Bakery. Grain’s operations include granaries, milling and dealings in the grain markets; Bakery operates a number of bakeries. The following data relates to the year ended 31st December:

Wholly Grains Group maintains an Internal Transfer Price system in which Grains transfers grains to Bakery at Full cost (except for allocated Head Office costs) plus 25% mark up. Bakery has the choice of buying from external suppliers, however, at the moment all of its grains come from Grains division. The total costs and sales transferred to Bakery from Grains are outlined below:

Divisional managers (DMs) have a significant input to all capital expenditure decisions and given authority to spend up to $100,000 on capital items as long as total spending remains within an amount provided for small projects in the authorised annual budget. Larger projects must be submitted by DMs to central management (CM) using group investment appraisal procedures. All day-to-day operations are delegated to DMs, whose performance is monitored with the aid of budgets and reports. The basis for appraising DM performance is currently under review and you have been approached as a consultant to advise Wholly Grains Group on this issue. At present divisions are treated as investment centres for DM performance appraisal, but there is disagreement as to whether return on capital employed or residual income is the better measure, and confusion about how these should be defined, as it is the DMs performance (not the economic performance of the divisions themselves) that is to be measured. The group Chairman has recommended that DM performance appraisal should be “simple and focussed on the bottom line” and she recommends “simply using divisional profit. You are supplied with details of a potential investment opportunity that could be undertaken by either divisional manager:

The cost of capital of Wholly Grains Group is 15% per annum. In the recent management meeting, the following debate takes place.

Geogre, the Group’s CEO reflects: “Our shareholders recently are complaining to me that they cannot see clearly the performance by top management. We already have return on investment and residual income as our main financial measures. Surely this is enough?”

Fina, the Groups’s CFO, responds: “I think they are concerned that we are basing top managers’ compensation package on these measures, which are objective enough, but they cannot compare how we are doing compared to industry peers and the general market trend. I think they are a bit cynical that we are being rewarded for general market fluctuations rather than our underlying efforts.”

The director of Bakery, Baker, interrupts: “Before talking about our shareholders and what measures should reflect the so-called “underlying performance”, we need to re-examine the adequacy of our ROI scheme. Grains department sell their grains to us at a Cost plus 25% transfer price. This contributes significantly to our department having a low ROI. Is ROI even a good and reliable financial measure in the first place?”

Required: a) Define and calculate, for each division, return on capital employed and residual income, and state any assumptions or reservations about the data you have used in your calculations.

b) Discuss the advantages and disadvantages of using each of the three contemplated approaches to DM performance appraisal.

c) Suggest how CM could determine the required level of performance in each case.

d) Demonstrate how the use of each of the three measures would affect each DMs decision regarding whether to accept the potential investment opportunity. Highlight in each case whether or not the DMs decision would be consistent with the overall Group goal of shareholder value maximisation, especially given the current economic situations.

e) Taking into the discussion at the recent management meeting, identify a number of financial measures that Wholly Grains Group can use to enable shareholders a better picture of the firm’s underlying financial performance compared to peers and industry. Comment on the advantages and disadvantages of each measure.

f) Based on the facts given and any other assumptions made, briefly comment on the appropriateness of the current transfer pricing system being used at Wholly Grains Group. Make recommendations on the changes (if any) desirable to make internal performance measurement and transfer pricing systems more equitable.

g) Make a clear recommendation to the Board of Wholly Grains Group in respect of the most appropriate measures to use for i) company’s performance appraisal, and ii) DM performance appraisal. Support your recommendation with the key reasons for your choice and outline briefly any potential limitations of the proposed approach to DM performance appraisal.
 

Sales Operating expenses: Direct Labour Direct Materials Depreciation Divisional overheads Head office costs (allocated) Divisional Profit Non-current assets (at NBV) Current assets Current liabilities Grain $000 44,000 8,700 25,600 700 5,300 440 40,740 3,260 Grain $000 10,000 11,500 3,000 Bakery $000 25,900 7,950 10,300 1,100 4,550 259 24,159 1,741 Bakery $000 9,000 5,500 2,000