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On page 75, 76 BPP practice and revision Kit F5 has the following question:
280 Biscuits and Cakes (6/12 amended) 39 minsThe 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 centre. 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 company’s target ROI, however, remains unchanged at 20% per annum. For each of
the last three months, Divisions B and C have maintained ROIs of 22% per annum and 23% per annum 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 $22.6mDivision B has now been offered an immediate opportunity to invest in new machinery at a cost of $2·12 million.The machinery is expected to have a useful economic life of four years, after which it could be sold for $200,000.Division B’s policy is to depreciate all of its machinery on a straight-line basis over the life of the asset. The machinery would be expected to expand Division B’s production capacity, resulting in an 8·5% increase in
contribution per month.Required
(d) Recalculate Division B’s expected annualised ROI and annualised RI, based on July’s budgeted operating statement after adjusting for the investment. State whether the managing director will be making a decision that is in the best interests of the company as a whole if ROI is used as the basis of the decision.The answer in the book is as follows:
(d) Division B’s revised annualised net profit and opening net assets after investment
Depreciation = ($2,120,000 – $200,000) / 48 months = $40,000 per month
Net profit for July = $311,000 + ($600,000 × 8.5%) – $40,000 = $322,000
Annualised net profit = $322,000 × 12 = $3,864,000
Opening net assets after investment = $23,200,000 + $2,120,000 = $25,320,000Division B ROI
ROI = (Net profit / Net assets) × 100%
= $3,864,000 / $25,320,000 × 100% = 15.26%
Division B will not proceed with the investment as it will cause a decrease in ROI.
Division B RI
$’000
Net profit 3,864
Less: imputed interest charge:
$25.32m × 10% (2,532)
Residual income 1,332
Based on the above calculation, it is clear that RI is higher with the investment. This would suggest that the company should proceed with the investment and shows that the use of ROI as a performance measure is likely to result in the manager of Division B making a decision that is not in the best interests of the company as a whole.I wonder that: The data given in this question has referred to the depreciation of Biscuits and Cakes; however, in the answer, there is no reference to depreciation to calculate ROI and RI of division B.
Please help me to explain this!
Thank you!But in the answer that you have typed, there is depreciation of $40,000 a month (which is straight line depreciation over 4 years).
The existing profit will already be after the existing depreciation, so there is only the extra depreciation on the new machinery to be considered.In this answer, I mean that the capital employed does not take into consideration the depreciation incurred during the year, but only take into consideration the opening net asset after investment, which is $ 25.32 million; despite the fact that in question the depreciation was referred, both on existing machinery and new machinery. In BPP F5 textbook, the capital employed was taken as the average of the opening capital employed and closing capital employed, which I think that it is more appropriate in this situation when the depreciation was mentioned.
It is arguable which figure to take for the capital employed – it can be the closing capital employed, or the average capital employed for the year, or the opening capital employed (on the basis that it is the assets at the start of the year that earn the profit for the year). There is no rule – it is up to the company to decide what is most appropriate/sensible.
In the exam it will be made clear which to use (or you will have no choice based on the information given).
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