SOTE TWAWEZA 2012

53 Pasta division

36 mins

A well-established food manufacturing and distribution company, specialising in Italian food products, currently has an annual turnover in excess of $15 million. At present, the company has three production and distribution divisions, each responsible for specific product groups. The summary information of the pasta division relating to divisional assets and profitability is as follows.
Pasta division

This division produces a wide range of both dried and fresh pasta products which it sells to both the supermarket sector and the restaurant trade. Last year the divisional figures were as follows. Investment in non-current assets Investment in working capital Operating profit $m 1.5 1.0 0.5

The company is keen to ensure that each division operates as an autonomous profit-making unit to ensure efficiency prevails and motivation and competitiveness are maximised. Managers are given as much freedom as possible to manage their divisions. Divisional budgets are set at the beginning of each year and these are then monitored on a month by month basis. Divisional managers are rewarded in terms of divisional return on investment. The company is currently considering expansion into a new but allied product range. This range consists of sauces and canned foods. Projected figures for the expansion into sauces and canned foods are as follows. Additional non-current assets required Additional investment in working capital Budgeted additional profit The company has a cost of capital of 15%. The manager of the pasta division has produced successful results over the past few years for her division. She and her staff have enjoyed handsome bonuses on the basis of return on investment. The company has traditionally calculated return on investment as operating profit as a percentage of return on all net divisional assets, and bonuses are paid as a percentage on this basis. The board proposes that the pasta division will be responsible for the expansion into sauces and canned foods.
Required

$m 0.75 0.35 0.198

(a) (b) (c)

(d)

Calculate the return on investment for the division both before and after the proposed divisional expansion. (4 marks) Calculate the residual income for the division both before and after the proposed divisional expansion. (4 marks) Using return on investment as a performance measure, determine whether the divisional manager will be happy to accept the proposed expansion. Explain how your answer would differ if residual income was used as a performance measure instead of return on investment. (5 marks) Briefly outline the advantages and disadvantages of return on investment and residual income as divisional performance measures. (7 marks)
(Total = 20 marks)

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Questions

SOTE TWAWEZA 2012

SOLUTION TO QUESTION 6.10

53 Pasta division
Text references. Return on investment and residual income are covered in Chapter 14. Top tips. You should have found this question very straightforward. Set out your workings clearly in parts (a) and (b). Underline the key words such as the need to do the calculations 'before' and 'after' in parts (a) and (b).

(a)
Before expansion $m 1.5 1.0 2.5 Additions $m +0.75 +0.35 After proposed expansion $m 2.25 1.35 3.60

Investment in non-current assets Investment in working capital Net divisional assets Operating profit Return on investment (b) Operating profit Imputed interest on net divisional assets Residual income

0.5 20.0%
Before expansion $m 0.500

+0.198

0.698 19.4%

After proposed expansion $m 0.698

($2.5m

15%)

0.375 0.125

($3.6m

15%)

0.540 0.158

168

Answers

SOTE TWAWEZA 2012

(c)

Using return on investment (ROI) as a performance measure, the divisional manager would not be happy to accept the proposed expansion. The ROI would reduce if the expansion went ahead, indicating a deterioration in the division's performance, and because bonuses are paid as a percentage on this basis, the manager would receive a lower bonus. If residual income (RI) was used as a performance measure the manager would be happy to accept the proposed expansion. This is because the RI would increase as a result of the expansion. This indicates an improvement in the division's performance and so the manager would receive a higher bonus.

(d)

ROI has the obvious advantages of being compatible with accounting reports and is easier to understand.

There are a number of disadvantages associated with both ROI and RI, however. (i) (ii) (iii) Both methods suffer from disadvantages in measuring profit (how should inventory be valued, how should arbitrary allocations of head office charges be dealt with) and investment (what basis to use). It is questionable whether a single measure is appropriate for measuring the complexity of divisional performance. If a division maintains the same annual profit, keeps the same assets without a policy of regular noncurrent asset replacement and values assets at net book value, ROI and RI will increase year by year as the assets get older, even though profits may be static. This can give a false impression of improving performance over time and acts to discourage managers from undertaking new investments.

In addition, ROI suffers from the following disadvantages. (i) The need to maintain ROI in the short-term can discourage managers from investing in new assets (since the average ROI of a division tends to fall in the early stages of a new investment) even if the new investment is beneficial to the group as a whole (because the investment's ROI is greater than the group's target rate of return). This focuses attention on short-run performance whereas investment decisions should be evaluated over their full life. RI can help to overcome this problem of sub-optimality and a lack of goal congruence by highlighting projects which return more than the cost of capital. It can be difficult to compare percentage ROI results of divisions if their activities are very different. RI can overcome this problem through the use of different interest rates for different divisions.

(ii)

There are also a number of disadvantages associated with RI: it does not facilitate comparison between divisions; neither does it relate the size of a division's income to the size of the investment. In these respects ROI is a better measure. The disadvantages of the two methods have a number of behavioural implications. Managers tend to favour proposals that produce excellent results in the short term (to ensure their performance appears favourable) but which, because they have little regard for the later life of their division's projects, are possibly unacceptable in the longer term. They will therefore disregard proposals that are in the best interests of the group as a whole. ROI and RI can therefore produce dysfunctional decision making.

Answers

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