Accounting for Management, 1/e

Subramania Ramanathan

CH 24 Responsibility Accounting:
1.
A company has two divisions A and B, each one is focusing on the manufacture of different
products. The central office has surplus funds of Rs. 50 lacs can be invested in the market to fetch a
return of 10%. However, the central office is considering investing the funds more profitably and
accordingly asked division A, the flagship division, to select any one or both of the two proposals as
given below:
Proposal I: This is a proposal envisaging the installation of new machines worth Rs. 25 lacs to expand
capacity to generate an annual savings of Rs. 280,000.
Proposal II: This is a proposal for development of a new product for utilization of the existing resources
more effectively. It is estimated that a development expenditure of Rs. 18 lakh will increase the
operating income by Rs. 234,000.
The divisional manager states that if neither of these proposals is taken up, his division will earn an
annual income of Rs. 250,000 on the existing investment of Rs, 20 lakh.
Required:
(i)

Compute the ROI of the two proposals and state which in our opinion will the manager of
division A will be inclined to choose for investment.
Compute the ROI of division A for the next year if:
(a) Proposal I is implemented
(b) Proposal II is implemented
(c) Both the proposals are implemented
As the manager of the central office state which of the two proposals will you recommend
for implementation?

(ii)

(iii)

Answer:
Division A:

(i)

Existing

Proposal I

Proposal II

Investment

Rs

2000,000

2500,000

1800,000

Income

Rs

250,000

280,000

234,000

ROI

12.5

11.2%

13%

The divisional manager will be inclined to choose proposal II as it yields a greater ROI than
he existing ROI.

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Accounting for Management, 1/e

(ii)

Subramania Ramanathan

The results of the three alternatives are as under:

With Proposal I

With Proposal II

With Both

Investment
Rs
4500,000
3800,000
6800,000
Income
Rs
530,000
484,000
764,000
ROI
%
11.77%
12.74%
11.24%
(iii)
Current investment of funds of Rs. 50 lakh will fetch an income at 10% of Rs. 500,000. With
the two proposals the company income will be as under:
With Proposal I
With Proposal II
With both
Investment:
Money market

Rs

2500,000

3200,000

700,000

Project investment

Rs

2500,000

1800,000

4300,000

Money market income @ 10%

Rs

250,000

320,000

70,000

Project income

Rs

280,000

234,000

514,000

Total

Rs

530,000

554,000

584,000

If no project investment

Rs

500,000

500,000

500,000

Increase in income

Rs

30,000

54,000

84,000

The central office manager will recommend investment in both the projects as it yields the
largest income.

2.
A company is organized in to three divisions namely P, Q and R. The financial results of the
three divisions for the year ended 31 March 2013 are summarized as follows:
Division P
Rs lakh

Division Q

Division R

Rs lakh

Rs lakh

Sales

45

112

54

Variable costs

12

35

15

Contribution

33

77

39

Fixed costs

24

60

28

17

11

Operating profit

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Accounting for Management, 1/e

Subramania Ramanathan

Capital Employed:
Fixed Assets

25

84

43

Net Current Assets

20

25

22

The weighted average cost of capital of the company is 13%. For RI purposes a rate of return of 12% is
considered. The companys tax rate is 30%.
Required:
(i)
(ii)
(iii)

Calculate the ROI, RI and EVATM

Comment on the performance of the three divisions
If the central office of the company wants to fix the target sales revenue of division R to
earn ROI of 20%, what increase in sales should the division generate?

Answer:
(i)
Computation of ROI, RI and EVATM :
Particulars
Division P
Rs
Operating Profit
900,000
Total assets employed
4,500,000
Return on Investment %
20.00

Division Q
Rs
1,700,000
10,900,000
15.60

Division R
Rs
1,100,000
6,500,000
16.92

Operating Profit
Total assets
Rate of return required %
Required return on assets
Residual Income

900,000
4,500,000
12.00
540,000
360,000

1,700,000
10,900,000
12.00
1,308,000
392,000

1,100,000
6,500,000
12.00
780,000
320,000

Operating Profit
Profit after tax @ 30%
WACC %
Total assets
Total Assets x WACC
EVA

900,000
630,000
13.00
4,500,000
585,000
45,000

1,700,000
1,190,000
13.00
10,900,000
1,417,000
-227,000

1,100,000
770,000
13.00
6,500,000
845,000
-75,000

(ii)
The ROI of division P is the highest but the RI is not the highest. EVA is positive. In the case of
division Q, even though the ROI is not the highest, RI is the highest but EVA is negative. In the case of
division R, ROI is in the second position but EVATM is in the negative. EVATM is a superior measure of
performance as it reflects after tax cash inflow. Considering these factors, division P is performing
better than the other two divisions.
(iii)

Profit required to earn 20% ROI:

Rs. (1100,000/16.92) x 20 = Rs. 1300,236

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Accounting for Management, 1/e

Subramania Ramanathan

PV Ratio:
Rs. (3900,000 x 100)/5400000 = 72.22%
Additional contribution desired: Rs. 1300,236 1100,000 = Rs 200,236
Additional sales required:
(200,236 x 100)/72.22 = Rs. 277,258
Total sales required to earn 20% ROI = Rs.5400,000 + 277,258 = Rs. 5677,258.

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