SOTE TWAWEZA 2012

PERFORMANCE MANAGEMENT 541 PREPARING FOR THE EXAMINATION

Solution 41
For each proposal, calculate a revised operating prot gure and a revised gure for yearend assets. In part (b) the nance charge for the residual income is calculated as 12% of the net assets gure. (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 prot will be reduced by the late payment penalty of 2,000. Therefore, ROSE 647,000 4, 310, 000 100 15.01%

This meets the target, so management will adopt this proposal and receive their bonuses. 20X2 No effect. The proposal to delay payment incurs expensive nance 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%. The proposal 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 operating prot. Therefore, ROSE 649,000 4, 720, 000 100 13.75%

20X2

Extra depreciation charges 40,000 and operation saving 76,000. Therefore, 36,000 280,000 100 12.9%

The ROSE for the proposed is

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, eventually the ROCE for this project will rise and assist in meeting the divisions target. This illustrates the major weakness of ROCE as a measure of performance in that the ROCE increases over the life of the asset and the initial low values may discourage divisional managers from making necessary protable 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 gures, this proposal is likely to be rejected. (b) Both performance indicators compare the prot generated with the assets used to produce them. ROCE is a ratio which may be used to compare operations irrespective of the scale of operations. Residual income (RI) is an absolute value that is dependent upon the scale of operation.

SOTE TWAWEZA 2012

542 PREPARING FOR THE EXAMINATION SOLUTIONS TO REVISION QUESTIONS P2

If the two divisions are reassessed using RI, we have the following.
Division K D Operating prot 649,000 120,000 Finance charge 528,000 58,000 RI 121,000 62,000

In this analysis, Division K has a better residual income, twice that of Division D, but this has required nine times the assets to achieve this result. Thus, it would not be appropriate to set the same target RI for divisions that have signicantly different asset values. Residual income, like ROCE, tends to increase over the life of an asset. That is, as the asset is depreciated, the nance charge decreases. However, so long as a new investment generates prot at a rate above the companys cost of capital, it will increase the total RI of the division. Thus, it is less likely to discourage new investment. The advantage of the ROCE ratio is that 1 years one companys result is comparable with another result. The RI may vary from year to year, or from company to company, as the market interest rate or company cost of capital varies. Both performance indicators value the assets at net book value, but this may not reect technological obsolescence compared with the organisations competitors. Many other factors may affect the divisions protability, for example calibre of management, degree of competition in the market place and so on. Thus, neither ROCE nor RI can be used on its own to measure how successfully a division has performed. Thus, I disagree with the nancial controllers proposal to merely replace one key indicator with another; a mixture of indicators is required. Working IRR, investmen inflow ratio 320,000 76, 000 4.21

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

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

On pure ROI, division Z is performing better than division Y; Division Y is earning a larger absolute amount by more than ve times, and is exceeding the target return on capital, thus Y is increasing the wealth of the company more than Z, but this is not reected in the ROI gures;