TUTORIAL PMS FINANCIAL MEASURES

QUESTION 1

a) Plumbing Division
Contribution margin = 1660000-540000 = 1120000
Profit margin = 1120000 - 220000 = 900000
ROI = 900000/7500000 = 12%

Industrial Division
Variable cost = 19600000 - 9600000 = 10000000
Profit margin = 9600000 - 3000000 = 6600000
Average operating asset = 6600000/15% = 44000000

b) Two ways the ROI can be improved is by increasing the return on sales in which
managers can increase the selling price so that the sales revenue will be higher. One
way for managers to increase return on sales is to set a strategic pricing by conducting
market research on how the consumers' purchasing behavior and set the price in line
with the price elasticity so that managers will be able to maximize profit while also having
the competitive advantage. The managers can also opt to strengthen its marketing and
advertising strategies to attract more customers and also retain current customers.

ROI also can be improved by reducing the invested capital. Managers should optimize
capital allocation by focusing on investments that give higher return and that is more
profitable to the business. Managers can also minimize its assets and inventory by using
the just in time approach, managers can avoid any excessive inventories as this
approach only buys inventories when needed during the production process and any
unused or underutilized assets should be sold off as it does not generate any return to
the business.
 c)

ROI EVA

Plumbing 12% EVA

Division = Net operating profit after tax -
(Capital employed × WACC)
= (RM 900,000 × 70%) - ( RM
7,500,000 × 10%)
= - RM 120,000

Industrial 15% EVA

Division = Net operating profit after tax -
(Capital employed × WACC)
= (RM 6,600,000 × 70%) - (RM
44,000,000 × 10%)
= RM 220,000

Performance The ROI for plumbing division is
12%, meanwhile for industrial
division, the ROI is 15%. This
implies that the industrial division's
performance is better than the
plumbing division by 3%.
Based on the EVA calculation, the
plumbing division generates a
negative value of RM120,000 while
the industrial division has a positive
value of RM220,000. This shows
that industrial division is performing
better than plumbing division.
d) Two ways to minimize the negative behavioral effects of ROI are:
1. Use a broader set of performance measures which encompass both long-term
and short-term measures as well as financial and non-financial measures. This is
to not solely rely on ROI in measuring the performance. By considering a broader
range of performance measures, it can reduce the risk of encouraging unethical
or short-term behavior solely for financial gain which could be detrimental
long-term performance.
2. Consider alternative ways of measuring invested capital to minimise
dysfunctional decisions and to ensure that the replacement of an asset does not
have such an adverse effect on ROI. For example, by using market values or
acquisition cost can minimize the negative effect of ROI due to invested capital.

e) The imputed interest charge utilized in the residual income and the Weighted Average
Cost of Capital (WACC) employed in Economic Value Added (EVA) calculations serve
distinct purposes. Residual income assesses the surplus income generated by a
business beyond the cost of equity capital, with the imputed interest charge representing
the opportunity cost of equity. It gauges whether a company is creating value by
exceeding its cost of equity. On the other hand, WACC in EVA incorporates both debt
and equity costs to determine the average cost of a company's capital structure. It is a
critical component in assessing whether the company is achieving returns that surpass
the overall cost of its capital. While the imputed interest charge hones in on the cost of
equity, the WACC provides a comprehensive view of the cost of capital in the broader
context of EVA analysis.

The weighted average cost of capital is used in the calculation of EVA, whereas in RI this
is not always the case. In the calculation of RI, an imputed interest is used, which is the
company’s required rate of return.
QUESTION 2

a) ROI (before acquisition)

= Profit / Invested Capital
= RM1,300,000 / (RM2,000,000 + RM2,470,000)
= RM1,300,000 / RM4,470,000
= 29.08%

ROI (after acquisition)

= (RM1,300,000 + RM450,000) / (RM4,470,000 + RM1,500,000 + RM1,100,000)
= RM1,750,000 / RM7,070,000
= 24.75%

RI (before acquisition)
= Profit - (Invested Capital x Imputed Interest Rate)
= RM1,300,000 - (RM4,470,000 x 13%)
= RM 718,900

RI (after acquisition)
= RM1,750,000 - (RM7,070,000 x 13%)
= RM 830,900

Evaluation:

By using ROI measure, before the acquisition, the ROI of Kitchen Electrical Division is
29.08%, meanwhile, after the acquisition, the ROI will reduce to 24.75%. Hence, if using
the ROI measure, the managers of Kitchen Electrical Division will reject the acquisition
because the ROI of the division decreases. The managers will think that they will be
negatively affected by the decrease, causing them not to accept the acquisition.

However, the managers can avoid this problem by using RI as a measure. Using RI, the
manager will accept the proposal as after the acquisition, the RI increases to RM830,900
as compared to the RI before the acquisition of RM 718,900. Even though the
 acquisition reduces the division’s ROI, the company will lose out on RM830,900 if the
proposal is not accepted.

b) Recognition and Public Acknowledgment

Outstanding managers can be publicly acknowledged and rewarded within the company
for their exceptional performance. This acknowledgment may involve awards,
achievement certificates, or praise from top management. Recognizing their hard work
and contributions can elevate their motivation and morale.

Career Advancement Opportunities

Excellent managers should be given opportunities to grow in their careers within the
company. This can include moving up to higher positions, leading important projects, or
managing bigger teams. Providing these advancement opportunities not only
acknowledges their current performance but also encourages them to keep doing well
and contribute to the company's success.

c) The behavioral problem associated with using ROI as a divisional performance measure
is ROI only focuses on short-term performance. Each divisional manager might only aim
to achieve a high ROI in the short term but obviously will be detrimental to the long-term
health of the division or the company as well as the company. To achieve the high ROI,
the managers might prioritize immediate gains by reducing the cost such as lowering the
salaries, reducing the research and development activities as well as using low- quality
materials. As a result, the divisions could harm the company's competitiveness and
growth prospects in the long term since both divisions decide to focus only on their ROI
and not as a company as a whole.

Next, the divisional managers might decide to reduce the invested capital through asset
disinvestment. The managers will reduce the capital invested by engaging in asset sales
or lease-back arrangements to contribute to the higher ROI. However, it can lead to a
loss of a division's productivity or competitive advantage as every division does not own
the capital and is binding with the contract which could be difficult to improve the
productivity of the division. Hence, both divisions in the companies could not maintain
the high ROI in the long run.
QUESTION 3

a) Before acquisition
ROI = profit/invested capital
ROI = 65000/500000
= 13%

RI = profit - (invested capital x imputed interest rate)

= 65000 - (500000 x 10%)
= 15000

After acquisition (Leasing)

ROI = profit/invested capital
ROI = (65000 + 40000)/500000
= 21%

RI = profit - (invested capital x imputed interest rate)

= 105000 - (500000 x 10%)
= 55000

After acquisition (Purchase)

ROI = profit/invested capital
ROI = (65000 + 40000+ 24000)/(500000 + 150000)
= 19.84%

RI = profit - (invested capital x imputed interest rate)

= 129000 - (650000 x 10%)
= 64000

The ROI for the company without the new project was 13% which is higher than the
required rate set by the company. The RI had a positive figure to show that there is
balance (residual) from the income.
With the new project, the ROI and RI are higher than without a new project for both
options, to purchase or to lease. However, the ROI from leasing which is 21% is higher
than from purchasing of 19.84%. The RI for leasing is also higher than purchasing.

The manager decided to lease the equipment because through leasing, the value of
average operating assets will not increase since it will be recognized as expenses.
Therefore, she can receive a high ROI since profit will increase due to the use of
equipment but the value of operating assets will remain the same due to leasing
activities.
b) Subject: Proposal to Adopt Residual Income (RI) as the Preferred Performance Measure

Dear Mr Takata,

I recommend transitioning from Return on Investment (ROI) to Residual Income (RI) as

our primary performance measure for investment center managers. This change is
prompted by the decision to lease equipment for a new project, which highlights RI's
suitability for our organization.

RI focuses on value creation, encourages cost-effective decisions, is adaptable to

various projects, offers clarity, and promotes long-term profitability. Its alignment with our
company's goals and the decision to lease equipment make RI a more relevant and
motivating performance metric.

I'm available for further discussion and adjustments as needed.

Sincerely,
Siti Aisyah
Ms Siti
Management Accountant
Kemunting Mining Bhd
QUESTION 4

a) Weighted-average cost of capital = [(after-tax cost of debt capital)(market value of

debt)+(cost of equity capital)(market value of equity)]/(market value of debt-market value
of equity)

Weighted-average cost of capital =

[(8%(1-30%))(20000000)+(12%)(60000000)]/(20000000+60000000)

Weighted-average cost of capital = 10.4%

b)

Eastern Division Western Division Northern Division

Operating profit 24% x RM 33 32% x RM 22 25% x RM 52

before tax million million million
= RM 7.92 million = RM 7.04 million = RM 13 million

Operating profit after RM 7.92m x 70% RM 7.04m x 70% RM 13m x 70%

tax = RM 5.54m = RM 4.93m = RM 9.1m

- (capital employed (48 + 22 - 6.2) x (45+35-6) x 10.4% (42+27-5.5) x

x WACC) 10.4% = (RM7.70m) 10.4%
= (RM 6.64m) = (RM6.60m)

EVA (RM 1.1m) (RM 2.77m) RM 2.5m

Total EVA (RM 1.37)

Based on the EVA, HNTB is in a financial crisis. Its substantial negative EVA merits the
immediate attention of the management team.
c) ROI = return on sales x investment turnover

Eastern Division Western Division Northern Division

Sales margin 24% 32% 25%

Sales revenue RM 33,000,000 RM 22,000,000 RM 52,000,000

Total net assets RM 63,800,000 RM 74,000,000 RM 63,500,000

Assets turnover RM 33,000,000 RM 22,000,000 RM 52,000,000

RM 63,800,000 RM 74,000,000 RM 63,500,000
= 0.5172 = 0.2973 = 0.8189

ROI 12.4% 9.5% 20.5%

The division that is entitled for special incentive is Northern Division because the ROI is
20.5% which is above the average ROI (16%).

d) By using EVA, it will encourage divisional managers to maximise the wealth of the
division. Even though managers may not have sufficient autonomy to make decisions
about financing and have inability to change the WACC, with EVA it would ensure the
divisional managers to only invest in projects that give highest returns.