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The management accounts for income read as follows:
Revenue 3,500m
COS 1,800m
Local administration 250m
IT cost 50m
Distribution 80m
Central administration 30m
Interest charges 90m
Net Profit 1200mIgnore taxation.
If the cost of capital is 12%, what is the division’s residual income?Sir residual income formula = operating or pretax profit – notional interest
But in this question in solution they have calculated controllable profit 1200+ 90+ 30+50
Why they have calculated controllable profit and
How ?The controllable profit is the profit that is controlled by the division.
Central administration costs are costs that are controlled centrally (at head office) and then charged to the division – the division has no control over the amount.
Divisions do not borrow money and therefore do not pay interest – it is the head office who borrows and pays interest. If they charge some of the interest to the division, as they have done here, then the division has no control over the amount charged.
As far as IT costs are concerned, the IT department will do work for the company as a whole and so it is again head office who will decide how to charge the expense between divisions. The division will have no control over the amount charged.
So all three of the above need adding back to the profit to determine the controllable profit.
But sir this is the only question I’ve seen RI calculation like this .. in all the other question so far I have calculated operating profit or PRE TAX profit — notional interest
Which one is correct to follow should I use this controllable profit for RI calculation in all the questions of RI ???
at first I calculated like net profit 1200+ Tax 90 = 1290I am confused noww
We certainly do take the profit before tax if tax is mentioned. However there is no tax mentioned in this question and so I do not know where you are getting it from.
We need to controllable profit and therefore we calculate the profit ignoring the non-controllable items as I have listed in my previous reply.
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