Divisionalisation ACCA Exam Question

Sliced Bread plc is a divisionalized company. Among its divisions are Grain and
Bakery. Grain's operations include granaries, milling and dealings in the grain
markets; Bakery operates a number of bakeries.
The following data relate to the year ended 30 November:

Grain Bakery
£000 £000
Sales 44,000 25,900
Gain on sale of plant 900

44,000 26,800

Direct labour 8,700 7,950

Direct materials 25,600 10,200
Depreciation 700 1,100
Divisional overheads 5,300 4,550
Head office costs (allocated) 440 268
40,740 24,068

Grain Bakery
£000 £000
Fixed assets (at cost less accumulated depreciation) 7,000 9,000
6,350 1,800
Stocks
Trade debtors 4,000 2,100
Cash at bank 1,500
Bank overdraft 750
Trade creditors 3,000 2,150

Divisional managements (DMs) are given authority to spend up to £20 000 on capital
items as long as total spending remains within an amount provided for small projects
in the annual budget. Larger projects, as well as sales of assets with book values in
excess of E20000, must be submitted to central management (CM). All day-to-day
operations are delegated to DMs, whose performance is monitored with the aid of
budgets and reports.
The basis for appraising DM performance is currently under review. At present
divisions are treated as investment centres for DM performance appraisal, but there
is disagreement as to whether return on capital employed or residual income is the
better measure. An alternative suggestion has been made that DM performance
should be appraised on the basis of controllable profit; this measure would exclude
depreciation and gains or losses on sale of assets, treating investment in fixed assets
as a CM responsibility.

The cost of capital of Sliced Bread plc is 15% per annum.

Requirements
(a) Calculate for both divisions the three measures (return on capital employed,
residual income and controllable profit) which are being considered by Sliced Bread
plc, and state any assumptions or reservations about the data you have used in your
calculations.
(5 marks)

(b) Examine the merits and problems of Sliced Bread plc's three contemplated
approaches to DM performance appraisal, and briefly suggest how CM could
determine the required level of performance in each case.
(15 marks)

(c) Discuss briefly whether further measures are needed for the effective appraisal of
DM performance.
(5 marks)
(Total 25 marks)
Q20.18
Linamix is the chemicals division of a large industrial corporation. George Elton, the
divisional general manager, is about to purchase new plant in order to manufacture a
new product. He can buy either the Aromatic or the Zoman plant, each of which
have the same capacity and expected four year life, but which differ in their capital
costs and expected net cash flows, as shown below:

Aromatic Zoman
Initial capital investment £6,400,000 £5,200,000
Net cash flows
(before tax)
2001 £2,400,000 £2,600,000
2002 £2,400,000 £2,200,000
2003 £2,400,000 £1,500,000
2004 £2,400,000 £1,000,000
Net present value £315,634 £189,615
(@ 16% p.a.)

In the above calculations it has been assumed that the plant will be installed and
paid for by the end of December 2000, and that the net cash flows accrue at the end
of each calendar year. Neither plant is expected to have a residual value after
decommissioning costs.
Like all other divisional managers in the corporation, Elton is expected to generate a
before tax return on his divisional investment in excess of 16% p.a., which he is
currently just managing to achieve. Anything less than a 16% return would make
him ineligible for a performance bonus and may reduce his pension when he retires
in early 2003. In calculating divisional returns, divisional assets are valued at net
book values at the beginning of the year. Depreciation is charged on a straight line
basis.

Requirements:
(a) Explain, with appropriate calculations, why neither return on investment nor
residual income would motivate Elton to invest in the process showing the higher net
present value. To what extent can the use of alternative accounting techniques assist
in reconciling the conflict between using accounting-based performance measures
and discounted cash flow investment appraisal techniques?
(12 marks)

(b) Managers tend to use post-tax cash flows to evaluate investment opportunities,
but to evaluate divisional and managerial performance on the basis of pre-tax profits.
Explain why this is so and discuss the potential problems that can arise, including
suggestions as to how such problems can be overcome.
(8 marks)

(c) Discuss what steps can be taken to avoid dysfunctional behaviour which is
motivated by accounting-based performance targets.
(5 marks)
(Total 25 marks)