Sodor plc is a manufacturing business specialising in the production of railway carriages. Its main business is located in the UK, but it has recently opened a manufacturing division (FC division) in Malaysia to produce the wheels for its carriages. The following information is available regarding the profit and assets of the division for the last two years (2013 and 2014):
[Note: all figures have been translated from Malaysian currency into £ at the appropriate rates during, or at the end of, the financial years.]
• The majority of FC’s sales are to internal customers, with just £100,000 of revenue earned from external sales in 2013. The internal sales revenue is four times as much as the external sales.
• Production costs for 2013 were £275,000, with additional administration costs equal to 40% of the production costs and a further selling and distribution overhead calculated at 28% of external sales revenue.
• The divisional operating assets were £1.1m at the end of 2012, and had increased by 12% in the year 2013.
• External sales revenue fell by 20% from its 2013 levels, offset by an increase of 45% in internal revenue.
• Production costs remained the same proportion of total sales revenue as they were in 2013, and the percentages and bases for additional administration and selling and distribution costs continued into 2014.
• Operating assets grew by just 10% over the year 2014.
Sodor plc has a company-wide cost of capital of 8%, and it uses average operating assets as the basis for all performance calculations.
You are the management accountant working for Sodor plc, and have been asked to prepare a report for your board of directors, focusing on the following tasks:
(a) Calculation of the Return on Investment (ROI) and the Residual Income (RI) for the FC division for the last 2 years, accompanied by comments on its performance. (20 marks)
(b) Suggestions of ways in which the performance results of this division may be improved in future years. (10 marks)
(c) Evaluation of the two performance measures that have been used in (a), particularly commenting on their suitability for assessing the performance of the divisional manager herself, as opposed to the overall divisional performance. This evaluation should include consideration of the following concepts that the board members are aware of, but do not fully understand:
• controllable vs divisional profit, and
• the use of opening, closing or average assets. (20 marks)
(d) The board is considering a number of ways to set the remuneration levels of the managers of its overseas divisions. It has decided to focus on the use of the Residual Income as the selected performance measure, but it still looking into a number of options regarding the incentive structure. Evaluate the following three alternative suggestions for divisional manager compensation schemes, and provide your recommendation to the board.
(i) A fixed basic salary with no performance related bonus,
(ii) A low (50% of current level) fixed basic salary with the potential to exceed current salary from a bonus based on divisional Residual Income, and
(iii) A low (50% of current level) fixed basic salary with the potential to exceed current salary from a bonus based on company-wide (rather than divisional) Residual Income. (25 marks)
(e) The board members are interested to know more about the concept of Economic Value Added (EVA(™)) which is being discussed as the “latest” development in performance measurement. Provide the following information to the board:
(i) Details of how EVA(™) is calculated, including the additional information that would be required over and above that used for ROI and RI calculations.
(ii) An evaluation of its suitability for an expanding business such as Sodor plc.
Marks will be awarded for producing a professional report (suitable for use in a business situation such as that described above) (10 marks)
Your report should also be appropriately referenced, where applicable, with marks for referencing being included within the professional report marks indicated above.
(Total marks = 100)
[Note: Use of appropriate numerical examples to illustrate points made in the above report will be rewarded, though the examples themselves should be placed in appendices and discussed in the body of the report.]
• The word limit for the report is 2,000 words in total, with a penalty of 10 marks if the word count exceeds 2,200 words (10% of the above limit).
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