Question

stay in Protected View Enable Editing attempt both questions. QUESTION 1: Divisional Performance Measurement and Project Appraisal Question 1 (a) Divisional Performance Measurement Zeta is a decentralised manufacturing entity, operating within the electronics industry. Zeta prides itself on giving its customers a well- made product, which reflects the latest trends and technologies in the marketplace. Zeta has two divisions, Alpha and Beta. Return on Investment (ROI) is the primary measure of each division's performance. Each divisional manager has their annual bonus linked to their division's ROI. However, the head office is considering the use of Residual Income (RI) as the basis for measuring bonuses in the future. Division Alpha has been consistently profitable, with gross profit margins remaining at a consistent level for the last three years. The divisional pre- tax operating profit has been steadily growing in the previous three years. However, the division has not undertaken any capital expenditure on new investments in recent years. The manager of Alpha is now considering investing in a new machine to use in production to replace its old machinery. Alpha financials Currently, the net assets of the division are £20m and the division's profit before tax is £3.8m. Included within Alpha's profit is an apportionment of head office costs of £0.6m. The division's cost of capital is 5%. Proposed investment The replacement machine will have a net cost of £3m and an expected useful life of ten years. This replacement machine is expected to increase the controllable profits of Alpha by 12%.

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Answer 1

Ans. I. ROI for Alpha before considering Proposed Investment = Profit before Tax / Net Assets = £3.8m / £20m = 19%

ROI for Alpha after considering Proposed Investment = (£3.8m x 1.12) / (£20m + £3m) = 18.50%

Ans. II. RI for Alpha before considering Proposed Investment = Profit before Tax - (Desired Return x Net Assets) = £3.8m - (5% x £20m) = £2.8m

RI for Alpha after considering Proposed Investment = £4.256m - (5% x £23m) = £3.106m

Ans. III. The ROI of the Alpha Division is decreasing as a result of proposed investments. However, the RI of the Alpha Division is increasing as a result of proposed investments.

The NPV shows that the proposed investment is beneficial to the division. Therefore, in order to motivate the divisional managers, Head Office shall introduce RI for calculation of divisional manager bonuses.

Ans. IV. Non-financial performance indicators also plays an important role. These are as follows:

(i) Customer Retention

(ii) Customer Satisfaction

(iii) After Sales Services

(iv) Reduction in Operating Cycle Time

(v) Increase in Productivity