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QUESTION
Cratchit Industries uses return on investment (RoI) as the sole performance measure for its divisions.
- Cratchit Industries uses return on investment (RoI) as the sole performance measure for its divisions. The minimum RoI required for each division is 15%, which is the company's present cost of capital. Income statements for two divisions (Scrooge and Marley) are reproduced below. These two divisions manufacture and sell similar products and therefore comparisons are considered meaningful, although, because of recent investments, the Marley Division has more modern plant than the Scrooge Division. Income statements for the last year are as follows:
- Scrooge Division £000s
- Marley Division £000s
- Sales
- 6,200
- 4,500
- Website development costs
- 600
- 900
- Product development costs
- 1,100
- 1,200
- Other costs
- 3,600
- 2,100
- Profit
- 900
- 300
- Investment
- 3,000
- 2,600
- Return on investment
- 30%
- 12%
- There is some concern within Cratchit Industries that measuring divisional performance based on RoI may lead to poor capital investment decisions. Both residual income (RI) and economic value added (EVA) have been suggested as better approaches to measuring divisional performance.
- The Scrooge Division is currently considering a new capital project which would involve investment of £500,000 and would yield a profit of £70,000 in year 1, after expensing a specific one-off investment in website development relating to the project of £60,000.
- In terms of EVA, it is estimated that any value creating activity would generate a return over four years.
- Requirement
- (a) Critically comment on the suitability of RoI, as used by Cratchit Industries, as the sole basis of measuring divisional performance.
- 3 Marks
- (b) Evaluate the recent performance of the Scrooge and Marley Divisions using both RI and EVA. Comment briefly on the results of the RoI, RI and EVA calculations.
- 12 Marks
- (c) Discuss the suggestion that RI and EVA are better approaches to measuring divisional performance.
- 5 Marks
- (d) Suggest what decision the manager of the Scrooge Division is likely to make with respect to the new capital project when evaluated using RoI, RI and EVA.
- 5 Marks
- Total 25 Marks
