It will be marginally beneficial in the short term, based on the ROI, to accept the new investment. (1/2 mark)

Divisional performance measurement using ROI
Division A:
ROI = Net Profit / investment x 100
= 12.49 / 82.8 x 100
=15.085%
Division B:
ROI = Net Profit / investment x 100
= 7.194 / 40.6 x 100
=17.72%

Divisional performance measurement using RI

Divisional performance after the new investment
Division A
ROI = Net Profit / investment x 100
= 23.49 / 97.8 x 100
= 24.02 %
Division B
ROI = Net Profit / investment x 100
= 2.194 / 16.6 x 100
= 13.21%

Residual Income after new investment.

Comment:

• If a decision about whether to proceed with the investments is made based on ROI, it is possible that the manager of Division A will accept the new proposal whereas the manager of Division B will reject the new proposal. Prior to the new investment Division A had 15.085%, though this is a bit lower than the target rate of return of 16% whiles Division B basket 17.72%. With the new investment Division A’s manager has a ROI of 24.02%, this is above the target rate of return, representing some 37.21% increase in the ROI of division A. Division B has ROI of 13.21%, this is lower than the target rate of return, representing some 25.45% reduction in the ROI of Division B.
• However, since Division B’s new ROI of 13.21% is higher than the firm’s cost of capital of 12%, accepting the new investment would encourage goal congruence and improves the firm’s overall performance. Behaviorally, Division B’s manger may not be motivated to venture into the new investment if his rewards are tired to the current level of performance. Accepting the new investment means a reduction in his incentives (bonuses).

ROI without the proposal: Profit/ Assets
.                                 GH¢198,000/ GH¢660,000
.                                        0.30 or 30%
ROI with the proposal:  GH¢192,000/600,000
.                                             0.32 or 32%
Decision: The disposal will improve the unit’s performance.

Contrasting Residual Income & Return on Income

• Return on investments is a financial ratio that measures the rate of return of a company’s investments. Companies use ROI to compare the efficiency of a number of investments. Residual income is another approach to measuring the performance of an investment. It is the net operating income an investment earns above the minimum required return on its operating assets.
• The residual income (RI) for a division is calculated by deducting from the divisional profit an imputed interest charge, based on the investment in the division. The return on investment (ROI) is the divisional profit expressed as a percentage of the investment in the division.
• It can be difficult to compare the percentage ROI results of divisions if their activities are very different: residual income can overcome this problem through the use of different interest rates for different divisions.
• Rigid adherence to the need to maintain ROI in the short term can discourage managers from investing in new assets, since average divisional ROI tends to fall in the early stages of a new investment. Residual income can overcome this problem by highlighting projects which return more than the cost of capital.                                                            (Any 3 points)

Comparing Residual Income & Return on Income

• Both methods suffer from disadvantages in measuring the profit and the investment in a division which include: Assets must be valued consistently at historical cost or at replacement cost. Neither valuation basis is ideal.
• Both methods use the same basic figure for profit and investment, but residual income produces an absolute measure whereas the return on investment is expressed as a percentage.
• Divisions might use different bases to value inventory and to calculate depreciation. Any charges made for the use of head office services or allocations of head office assets to divisions are likely to be arbitrary.              (Any 2 points)

Advantages of ROI & RI

• Focus management’s attention upon earning the best profit possible on the capital (total assets) available.
• Serve as a yardstick in measuring management’s efficiency and effectiveness in managing the company as a whole and its major divisions or departments.
• Tie together the many phases of financial planning, sales objectives, cost control, and the profit goal.
• Afford comparison of managerial results both internally and externally.
• Develop a keener sense of responsibility and team effort in divisional and departmental managers by enabling them to measure and evaluate their own activities in the light of the results achieved by other managers.            (Any 2 points)

Comment:
The ROI will fall in the short term if the new investment is undertaken. This is a problem which often arises with ROI, as noted in part (b) of this solution.

Comment:
The Residual Income will increase in the short term if the new investment is undertaken.

Costs centres are responsibility centres where the managers have authority only to incur costs. These centres only incur costs but do not directly generate revenues. Managers of such costs centres are therefore evaluated based on their ability to control costs. That is, the manager’s ability to meet the goals of budgeted controllable costs becomes the main focus. The evaluation reports for the centre compare the actual controllable costs with flexed controllable costs budget data.

Managers have responsibility to incur costs as well as generate revenues. Managers of these centres are therefore evaluated based on the profitability of their centres. To evaluate the performance of managers of profit centres, information on controllable costs and revenues are gathered. Fixed costs must be distinguished between direct and indirect costs. The profitability of these centres is measured by the controllable margin (contribution less controllable fixed costs)

In addition to incurring costs and expenses and generating revenues, have control over investment decisions (acquisition and disposal of long term assets). Managers of investment centres are evaluated both on the profitability of the centres they manage and the rate of return on the funds invested. Since investment centre managers have control or significant influence over investment funds, the primary basis for evaluating the performance of the managers is the return on investment.

If Pee’s offer is accepted.

No, Anim ventures should not accept Uncle Pee’s offer because the entire organisation would be worse off. Loss of overall profit would be GHS8,750 (GHS5,500 +GHS3,250).

Alternative Solution: Assuming the company collects the anticipated repair charge on all pairs of shoes upfront.

• Pee ventures ability to meet the quality standards of Anim ventures.
• Timely delivery of after sales repair services.
• Probable closure of the repairs department of Anim ventures due to reduced numbers.
• Uncertain customer response if they get to know that the repair works are outsourced.