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EXAMINATION

541PERFORMANCE MANAGEMENT

Solution 41For each proposal, calculate a revised operating profit figure and a revised figure for year-end assets. In part (b) the finance charge for the residual income is calculated as 12% ofthe net assets figure.

(a) The proposal to defer payment would have the following effects: 20X1 Net assets at year end will be reduced to 4,310,000 and operating profit

will be reduced by the late payment penalty of 2,000. Therefore,

ROSE647,000

100 15.01% 4 310 000, ,

This meets the target, so management will adopt this proposal and receive their bonuses. 20X2 No effect. The proposal to delay payment incurs expensive finance costs:

2 000

90 000

,

,

100 12.2% for 12 days (or 1/30.4 of a year)

which is an annual rate of ((1.022)30.4 1) 100: that is approximately 94%. Theproposal to replace the oldest machine tools would have the following effects.

20X1 Net assets at year end increased by 320,000 and no effect upon operatingprofit. Therefore,

ROSE649,000

100 13.75% 4 720 000, ,

20X2 Extra depreciation charges 40,000 and operation saving 76,000. Therefore,

The ROSE for the proposed is36,000

280,000100 12.9%

This will not help to achieve an overall divisional ROCE of 15%.The proposal to replace old assets will not increase the divisional ROCE in the

short term. However, as the asset value of this new machinery declines, eventuallythe ROCE for this project will rise and assist in meeting the divisions target. This illus-trates the major weakness of ROCE as a measure of performance in that the ROCEincreases over the life of the asset and the initial low values may discourage divisional

managers from making necessary profitable investments.This proposal has an internal rate of return of 17% (see working) which denotes a

relatively attractive proposal. However, with the emphasis on short-term ROCE fig-ures, this proposal is likely to be rejected.

(b) Both performance indicators compare the profit generated with the assets used toproduce them. ROCE is a ratio which may be used to compare operations irrespectiveof the scale of operations. Residual income (RI) is an absolute value that is dependentupon the scale of operation.

E TWAWEZA 2012

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RTHEEXAMINATION

SOLUTIONS TO REVISION QUESTIONS P2542

If the two divisions are reassessed using RI, we have the following.

Operating profit Finance charge RIDivision

K 649,000 528,000 121,000D 120,000 58,000 62,000

In this analysis, Division K has a better residual income, twice that of Division D, butthis has required nine times the assets to achieve this result. Thus, it would not be appro-priate to set the same target RI for divisions that have significantly different asset values.

Residual income, like ROCE, tends to increase over the life of an asset. That is, as theasset is depreciated, the finance charge decreases. However, so long as a new investmentgenerates profit at a rate above the companys cost of capital, it will increase the total RI ofthe division. Thus, it is less likely to discourage new investment.

The advantage of the ROCE ratio is that 1 years one companys result is comparablewith another result. The RI may vary from year to year, or from company to company, asthe market interest rate or company cost of capital varies.

Both performance indicators value the assets at net book value, but this may not reflecttechnological obsolescence compared with the organisations competitors. Many other fac-tors may affect the divisions profitability, for example calibre of management, degree ofcompetition in the market place and so on. Thus, neither ROCE nor RI can be used on itsown to measure how successfully a division has performed.

Thus, I disagree with the financial controllers proposal to merely replace one key indi-cator with another; a mixture of indicators is required.

Working

IRR, investmen inflow ratio

320,000

4.2176 000,

From annuity tables the sum of discount factors over 8 years that equals 4.208 is for 17%.Therefore IRR 17%.

Solution 42

(a)ROI Y Z

m m

Monthly net income 0.122 0.021Annualised net income 1.464 0.252Divisional net assets 9.76 1.26ROI 15% 20%

The following comments can be made regarding the relative performance of the twodivisions:

On pure ROI, division Z is performing better than division Y; Division Y is earning a larger absolute amount by more than five times, and is

exceeding the target return on capital, thus Y is increasing the wealth of the com-pany more than Z, but this is not reflected in the ROI figures;

E TWAWEZA 2012