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A company’s income statement and statement of financial position for the year just ended and the previous year are as follows.
Income Statement
| Year just ended (Year 2) |
Previous year (Year 1) |
|
|---|---|---|
| Profit before interest and tax | 80,000 | 62,000 |
| Interest cost | 8,000 | 6,000 |
| Profit before tax | 72,000 | 56,000 |
| Tax at 25% | 18,000 | 14,000 |
| Profit after tax | 54,000 | 42,000 |
| Dividends paid | 29,000 | 24,000 |
| Retained profit | 25,000 | 18,000 |
Statement of Financial Position (End of Year)
| Year just ended (Year 2) |
Previous year (Year 1) |
|
|---|---|---|
| Non–current assets | 280,000 | 265,000 |
| Net current assets | 200,000 | 170,000 |
| Total assets | 480,000 | 435,000 |
| Shareholder’s funds | 370,000 | 345,000 |
| Long–term and medium–term debts | 110,000 | 90,000 |
| Total equity and liabilities | 480,000 | 435,000 |
Notes:
- Capital employed at the beginning of Year 1 was $410 million.
- The company had non-capitalised leased assets of $18 million in each of the past three years. These assets are not subject to depreciation
- The estimated cost of equity in Year 2 was 12% and the cost of debt was 8%. The estimated cost of equity in Year 1 was 10% and the cost of debt was 7%
- The company’s target capital structure is 50% equity and 50% debt.
- It should be assumed that accounting depreciation was equal to economic depreciation, in each of the two years, and that this was also the amount used for the calculation of the tax charge in each year. (The purpose of this assumption is to remove the need to make an adjustment to get from accounting depreciation and to economic depreciation, and to remove the need for adjustments to capital employed.)
- Other non-cash expenses were $16 million in Year 2 and $14 million in Year 1.
REQUIRED
Use the information provided to calculate a figure for EVA in each of the two years, Year 2 and Year 1.
Return on investment (ROI), residual income (RI) and Economic Value Added (EVA) are three common financial measures for evaluating investment returns particularly among divisions in a decentralized company. Below shows the income statement and the partial statement of financial position of a division of PBE Co Ltd.
| TZS in million | |
|---|---|
| Sales | 550 |
| Cost of goods sold | 275 |
| Other expenses | 75 |
| Profit before tax | 200 |
| Tax (35%) | 70 |
| Profit after tax | 130 |
Assets
| TZS in million | |
|---|---|
| Property, plants and equipment | 1,170 |
| Less: Accumulated depreciation | (360) |
| Net fixed assets | 810 |
| Other assets | 110 |
| Net working capital | 80 |
| Total assets less current liabilities | 1,000 |
REQUIRED:
- Define and calculate the return on investment of that division. (3 marks)
- Suggest THREE ways to increase the return on investment. (6 marks)
- Briefly explain one major weakness of ROI. (3 marks)
- Briefly explain what EVA is and one of its major weaknesses. (3 marks)
- If the cost of capital is 10%, calculate the EVA. (3 marks)
- Suggest one advantage of decentralized corporate structure. (2 marks)
Tawala PLC consists of several autonomous divisions. At present the performance of each division is evaluated on the basis of its Residual Income. In the Residual Income calculation, a cost of capital of 10% is assumed in each division.
The following are summarised Income Statements for two of Tawala’s divisions for the financial year ended 31st December 2024:
| Division X | Division Y | |
|---|---|---|
| Sales | 1,000,000,000 | 670,000,000 |
| Divisional variable costs | 580,000,000 | 254,000,000 |
| Divisional fixed costs | 160,000,000 | 270,000,000 |
| Divisional contribution to corporate profits | 260,000,000 | 146,000,000 |
| Allocation of costs incurred at corporate HQ | 74,000,000 | 52,000,000 |
| Divisional profit | 186,000,000 | 94,000,000 |
In accordance with the company’s performance measurement rules, net assets are measured at their net book value for purposes of the Residual Income calculation. Summary balance sheets for the two divisions at 31st December 2024 are as follows:
| Division X | Division Y | |
|---|---|---|
| Non-current assets (Net book value) | 890,000,000 | 480,000,000 |
| Current assets | 575,000,000 | 290,000,000 |
| Current liabilities | 235,000,000 | 180,000,000 |
| Net assets | 1,230,000,000 | 590,000,000 |
The non-current assets were revalued in the accounts at their market values one year ago (i.e., at 31st December 2023). In the Income Statements provided above, divisional fixed costs for 2024 include depreciation of TZS 100,000,000 in Division X and TZS 60,000,000 in Division Y. These charges were calculated on a straight-line basis in accordance with the company’s normal accounting rules. However, it is estimated that the market values of the non-current assets diminished by TZS 80,000,000 (Division X) and 40,000,000 (Division Y) during 2024. Neither division purchased or sold any non-current assets during 2024.
Both divisions launched major new products early in 2024 and spent significant amounts on advertising so as to quickly build up market share for new products. These expenditures were TZS 18,000,000 by Division X and 24,000,000 by Division Y. These 2024 advertising expenditures are expected to benefit the products concerned throughout their product lifecycles, which management of each division estimate will be of 3 years duration.
Division Y spent TZS 32,000,000 on research and development (R & D) in 2023 and a further TZS 68,000,000 on R & D in 2024. In accordance with the company’s normal accounting rules, these expenditures were written off in full as divisional fixed costs in the year of expenditure. The manager of Division Y believes that each of these expenditures is likely to benefit the division commercially over a 4-year period beginning in the year of expenditure. There were no R & D expenditures by Division X in 2023 or 2024 because the manager of that division was concerned about the negative effect on reported profits of R & D expenditures.
Residual Income is the divisional performance measure used in Tawala PLC at present. However, the company’s senior management team is considering the use of EVA, in the belief that EVA would more strongly motivate division managers to pursue shareholder value creation.
REQUIRED: Conduct performance evaluation using Residual Income and EVA.
Ebwele Limited manufactures a standard product and the following report has been prepared in respect of a recent month:-
| Budget | Actual | Variances | |
|---|---|---|---|
| Sales and production (units) | 4,000 | 3,800 | |
| Direct materials consumed (kg) | 24,000 | 21,500 | |
| Direct labour hours | 10,000 | 9,800 | |
| Sales | 136,000,000 | 125,000,000 | (11,000,000) |
| Direct wages | 40,000,000 | 41,000,000 | (1,000,000) |
| Direct materials | 48,000,000 | 46,000,000 | 2,000,000 |
| Variable overheads | 20,000,000 | 18,000,000 | 2,000,000 |
| Fixed overhead | 12,000,000 | 11,500,000 | 500,000 |
| Total Cost | 120,000,000 | 116,500,000 | 3,500,000 |
| Net profit (loss) | 16,000,000 | 8,500,000 | (7,900,000) |
Variable overheads are applied at a rate per direct labour hour.
The direct labour hour rate was increased by Tshs. 200 per hour from the beginning of the month, the market price of direct materials was Tsh. 2,100 per kg. During the month, the budget figures were not adjusted in respect of any changes arising from these factors.
The company uses variable costing method.
REQUIRED:
- Comment on the report and any limitations you consider it may have.
- Using the information provided, prepare a detailed analysis of the sales and cost variances for the period and a statement reconciling, the budgeted and actual profit figures. Your analysis should distinguish between planning and operating variances.
- What are relevant costs? In decision- making, relevant costs always determine which alternative should be chosen. do you agree? Explain.
-
Nik-Dik Companypr9oduces two products. Nik and Dik. The company's segmented income statement for a typical month is shown below:
Nik (Shs.) Dik (Shs.) Total (Shs.) Sales 1,500,000 800,000 2,300,000 Less: Variable costs 800,000 460,000 1,260,000 Contribution margin 700,000 340,000 1,040,000 Less: Direct fixed costs 200,000 380,000 580,000 Segment profit / (loss) 500,000 (40,000) 460,000 Less: Common fixed costs 300,000 Net income 160,000 The production of Nik needs a sub-assembly part that is purchased from an external supplier for Shs. 250/= per unit. Each month it is estimated that 2,000 units are required of this sub-assembly part. there are no ending inventories of sub-assembly parts and finished goods.
The variable costs per unit to produce the sub-assembly are as follows:
Cost Component Amount (Shs.) Material 20/= Direct labour 30/= Variable overhead 20/= The management is considering the possibility of producing the sub-assembly rather than buying it. In order to increase the current productive capacity, two alternatives are being considered:
- Lease the needed space and equipment at a cost of Shs. 350,000/= per month.. this will require employing a foreman for Shs. 20,000/= a month. There are no other fixed costs.
- Stop producing and selling Dik. the existing equipment and space can be utilized to produce the sub-assembly. the direct fixed expenses to do this will remain Shs. 380,000/=
REQUIRED
- assume that if product Dik is dropped there will be no effect on the sales of product Nik. should the company make or buy the sub assembly? If the decision is to make, which of the alternatives should be chosen to increase capacity? Explain your choice and support it with calculations.
- assume that dropping Dik will decrease sales of Nik by 6%. Will the decision be the same as in (i) above? Support your answer with calculations.
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