Solution for Managerial Accounting Exam

Calculation and Explanation of the Results
Section A
(a)Calculate the annualised Return on Investment (ROI) for divisions A and B, and discuss the relative performance of the two divisions using the ROI data and other information given above.
Answer:
The Annual Return on Investment is the measure of the company’s efficiency in converting the annual investment (It may be in capital and Inventory or nay other from) made by the investors into the net profits. The formula for the calculation of ROI is (Net Income/Net Capital (assets)). The company’s efficiency and sustainability can be analyzed effective by comparing its ROI with the competing company or the industry average. Thus by analyzing the calculations of Annual Return on Investment of both the divisions (A and B) of a large company, we can make close perception of the company’s performance. The annual return on investment for the division A is 1.25% while that of the division B is 1.67%. Thus we can easily observe the difference between the figures and so the efficiency of the divisions. It can be inferred that the division A is less efficient in converting the investment into profits as compared to the division B. Thus the investors would be more inclined to make investment in the division B instead of the division A. The following are the Calculations for determining the Return on Investment for Both the Divisions (A and B). The information given regarding the divisions further helps us in determining the standard of these divisions. As from the above information, by comparing the Revenues of both the divisions we can determine that the Division A is more effective in generating the Revenues as compared to the division B. Further the division A is also effective in minimizing the variable cost, thus it has great contribution than the division B (£555000 for A and £243000 for B). The Problem with the division A, which results in overall smaller profits, is the fixed costs related to the division A. As the fixed costs incurred by the division A are considerably greater than the fixed costs incurred by the division B. Due to the greater fixed costs and central costs, Division A is unable to make greater net income as compared to Division B. Thus from all the above inferences we can declare that the division A is more effective than division B , but the problem with the division A is only of the cost that are associated with it. So in order to increase the net income for the division A, the Company has to focus on the cost and try to reduce the costs related to division A, instead of doubting its efficiency.
Formula = Net Income/Net Investment (assets))

A

B

Net income before tax

 $                    122,000

 $                       21,000

Annual Net Income before tax

 $                 1,464,000

 $                     252,000

Total Divisional Net Assets

 $                 9,760,000

 $                  1,260,000

Annual Total Divisional Net Assets

 $             117,120,000

 $                15,120,000

Expected Return on Capital

12%

12%

Annual Return on Investment

1.25%

1.67%

(b)   Calculate the annualised Residual Income (RI) for divisions A and B, and explain the implications of this information for the evaluation of the divisions’ performance.
Answer:
The annualised Residual Income measures that, whether the company is able to earn the minimum required return or not, if so then how much. If the cost of capital is large the required return is also greater. The residual income represents the income which is left after paying for the interest on all the relating debts. The formula for the calculation of the residual income is (Net Profit-(Required Return*Net assets)). By comparing the residual income of both the divisions, it can be easily perceived that, both the divisions are unable to make the minimum required return. As the residual income is the measure of the net profits in excess to the minimum of the required return, but both the divisions are unable to attain the minimum required return, hence there is no question of the excess profit. The value of the residual income is more in negative for the division A as compared to the division B. Thus this shows that the overall efficiency of division A, in generating the net profits is far less than the efficiency of division B.
Formula= (Net Profit-(Required Return*Net assets))

A

B

Net income before tax

 $                   122,000

 $                      21,000

Annual Net Income before tax

 $                1,464,000

 $                    252,000

Total Divisional Net Assets

 $                9,760,000

 $                 1,260,000

Annual Total Divisional Net Assets

 $            117,120,000

 $               15,120,000

Expected Return on Capital

12%

12%

Annual Return on Capital

1.25%

1.67%

Annual Residual Income

 $                   (1,342,000)

 $                       (231,000)

(c)Discuss the strengths and weaknesses of ROI and RI as methods of assessing the performance of divisions.  Explain two further methods of assessment of divisional performance that could be used in addition to ROI or RI.
Answer:
The strengths and weaknesses of ROI and RI depend on the extent to which we are dependent on such ratios in making the financial decisions. The ROI gives us the hunch of the performance of division, but it does not explicitly explain the components and determinants of performance.
Strengths:
Return on Investment (ROI) is a standardize way of measuring the financial efficiency of the firms, how much the firm is effective in making profits from a particular investment. This ratio is simple to use and hence it can give the overall performance evaluation. Further this ratio enables the analysts to focus particularly on the net profit of the company, which is the main purpose of running a company. Moreover it combines many parts of financial instruments such as the sales objectives (Sales Turnover) and the profit goal (Asset Turnover). Apart from ROI, RI is used to measure the risk associated with the particular investment. As it determines the capacity of the company to which it
Weaknesses:
As ROI only considers the net profits, it may not depict the true picture of the company’s performance. For instance, there may be a division which is generating larger revenues but also incurring greater costs, thus result in small profits for the division. Even if it is quite good in generating revenues, it is not making the net profits. So ROI only focuses on the results (Net Profits), not on how the division is performing, thus ROI would not be good for measuring the division’s performance. Apart from this, RI also cannot be used in order to compare the performance of the divisions. As it is only related to division’s particular investment and liabilities. Thus its value only depends on the division’s components.
The other methods which can be used in the place of ROI and RI, for comparing the division’s performance are “Variance analysis” and the “Ratio Analysis”. In the Variance analysis the division performance is evaluated in the terms of variance of the projected amounts relating to the division and the actual amounts which the division incur. Thus this method can be useful in comparing the division’s performance, as it measure how much the division has deviated from the expected amounts. Further the other method for comparing the division’s performance is through the ratio analysis. As by comparing the profitability and liquidity ratios we can compare the performance of the two divisions.
(d)
Discuss the advantages and disadvantages of allowing the managers to participate actively in the setting of the budgets for their divisions.
Delegating the authority can result in greater benefits and at the same time; cause the discrepancies in the company’s budget.
Advantages:
There are a number of benefits in delegating the authority to the mangers of the particular division. As the managers know the scenarios of their division quite well than the others, hence they can figure more accurately, what is good for a division and what is bad. By giving them the power or by considering their suggestion actively in the division’s budget would allow greater probability and more stability in division’s projected and actual amounts. Furthermore division would become more responsive and agile to the changing external environment, if it manager himself/herself adjusts the budget according to the needs. Furthermore by giving importance to the manger would make the manager from loyal to the work and he/she will be more motivated. This motivation would then ultimately result in greater division’s profits. 
Disadvantages:
There are also many disadvantages in giving due importance to the manger’s point of view in setting the budget for his/ her division. As being responsible for his/her own division can deviate the manager’s goal from the organization’s overall goals. The manager may end up in incurring greater costs if he/ she has the control over the budget. Furthermore the company’s top management may lose its influence by giving the decisions in the hands of the managers. The efficiency of division may also fall when there would be no bounded goals for the division. As the division would be inclined to go for the greater costs, when they would not have any hard and fast constraints.

 

(e)
Discuss the problems a company may have by looking at short term profit as a measure of performance.
The Company may suffer from greater loss in the long run if it focuses only the short run profits as the measure of the profitability. The company that focuses only the short run may go for the short run profits, without realizing the impact of the short run over the long run and cost the company has to pay in long. For instance the company may increase it profits in a short run by reducing the quality of its products. The company’s performance may appear to be boosting, but only for the short run as in the long run the customers may not trust the company and company’s sales may decrease considerably. Thus company’s good performance in the short run does not assure the company’s profitability in the long run. The performance evaluation for a company must be the hybrid of both the short term and the long term. As the company cannot perform well in the long run if do not perform good in the short run. Also it cannot perform better in the short run if it does not have feasibility for the long run. Furthermore company may use all the available cash in order to ensure the short term profits which would leave the company with least cash for the future operations. The company may collapse fully if it considers only the short run profits as the measure of the profitability.
Question No 2
(a)
Describe the advantages and disadvantages that an organization might experience if it adopts a decentralized structure.
The decentralized structure can be described as the one in which the organizations do not have the rigid and the bureaucratic structure. The authority do not reside only in the higher authorities, rather the lower management also has the authority to make certain decisions. The company’s culture is not much formal, if it has decentralized structure.
Advantages:
The company can earn many benefits of having decentralized structure for the organization. As the company, when delegates the power to the lower management it ensure greater flexibility. As the company would be more responsive to the ever changing demands of the environment. The company’s profitability may also increase if it company’s management has been successful in delegating the optimal authority to its subordinates. Decentralized structure can increase the organization loyalty for the employees working in it. The employee would be more committed towards the company’s goals. There would also be greater chances of the innovation in a decentralized structure.
Disadvantages:
The decentralized structure may also cause great hindrance for the company to earn greater profits. As in the decentralized structure the company may lose the power to control and the power to make the employees accountable. The company may not achieve their ultimate goal, may be due to inconsistence between the goals of the employees of company. As in decentralize structured company the employee may take a decision which will only be important to that particular employee, not the whole company. Furthermore the employee may lose the team spirit to work collectively, when they would have the fragmented structure in the company.
The company’s performance may also increase and decrease by the decentralized structure depending on the extent to which the structure of the company is decentralized.
(b)
Explain the term ‘transfer price’ and identify the different methods that an organization could use to determine the price it uses to transfer goods or services from one division to another.
In the decentralized structure the company has to take equal care of the division’s performance in the context of that particular division. As the conditions for every division of a company may be different, hence there would be different standards on which the performance of that division should be evaluated. For this purpose the company has to take care of some division related numbers such division profits, investments and the “Transfer Price”. Transfer price is such a price which one division of a company charges another division of the same company for a product transferred between the two divisions. Transfer prices allow the company to make the optimal decision which would in favor of every division, regardless of its condition.
Further there are other methods which are used by the companies in order to determine the price which one division should charge from the other division. These methods are

  • Market Based Transfer Pricing

Market Based Transfer Price is one which is currently prevailing in the market. 

  • Negotiated Based Transfer Pricing

Negotiated Transfer Price is negotiated manually by the mangers of the divisions, both the mangers must satisfy on this price.

  • Cost Based Transfer Pricing

Cost Based Transfer Price is determined from the costs that are being incurred by the company, in the production of a particular good for which that transfer price is being calculated.
(c)
Discuss the problems that arise specifically when determining transfer prices where divisions are located in different countries
The problems that arise when the divisions are located in the different countries are more related to the currency exchange rates of those particular countries. As different countries usually have different currencies, which have different values (Exchange Rates). The problems that the divisions have to face in determining the transfer prices, being in the different countries are that the divisions are unable to find the value of the product in the terms of amount of the foreign currency. The division also have to face the additional costs related to the exchange rates, for converting on currency into another.
(d)
Discuss five purposes of budgets;explain the difference between participative and non-participative budgeting, the advantages and disadvantages
The following are the five purposes of the Budgets;

  • Control the uncertainty in the future amounts.
  • Reduce the costs
  • Ensuring the feasibility of Projects
  • Establishing Goals to achieve
  • Reducing the Stress

Participative Management:
Participative management is that in which the participation of the employees is also given due respect in making the organizational decisions. The participative management can increase the employee’s job loyalty and at the same time the management may lose its control over the employees. 
Non -Participative Management:
Non-Participative management is the one in which the opinion of the employees are not considered for making the organizational decision. Non-Participative management result in firm control of management in determining the organizational goals but at the same time it may also increase the employee turnover rate.
Question No 3
(a)Explain the arguments for using the profit measure as the all-encompassing measure of the performance of a business.
The performance of the company is only analysed by the stake holders in order to determine its ability to make profits. The company which would be able to make the greater profits would always attract the potential stake holders. The company which is unable to make profits would ultimately be perceived to have low performance. Thus the stakeholders are only concerned with the net profits the company would be earning. The company’s performance thus must be evaluated by the net profits that company is making. If the company is making greater revenue but also incurring greater costs, no preference would be given to such company as it is not much efficient in making the net profits.
(b)
Explain the limitations of this profit-measurement approach and of undue dependence on the profit measure:
The limitations of the profit measurement approach are such that this approach may not describe the company’s operational performance, how efficiently the company is performing its operations. Further this approach also does not provide any information of regarding the different product that the company is customizing. The company may have the products which are expected to make good profits but are not performing well, thus the profit approach may not explicitly describe the performance of different product of the company. On the other hand “undue dependence” on the profit measure may also cause problems regarding the ability of a company to make net profits. As the company if not focusing profits, may run bankrupt, profits are due important for sustainability of the company.
(c)
Explain the problems of using a broad range of non-financial measures for the short- and long-term control of a business
The problems that may be faced by the company when it uses a broad range of the non-financial measures for the short and long term are more related to the performance of company’s operational activities. As it is quite important for the company to maintain the required amount of cash and other liquidate devices for its continuous sustainability. If the company have the broad range of control over the non-financial measure, the company’s performance may affect as the result of cumulative effect of such negligence. The company also has to maintain certain amount of   non-financial amounts in order to keep the company stable in case of any discrepancies.

 

 

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