PPM 5-2

1. XEN CO

The following information is available for Xen Co, a manufacturing company. You are provided with an extract from the Statement of Profit or Loss:

$

Operating profit                         42,000

Interest charges                        (16,000)

––––––

Profit before tax                        26,000

Taxation                                      (5,460)

––––––

20,540

Xen Co has an operating profit margin of 15%. You are provided with an extract from its Statement of Financial Position:

$

Equity and reserves

Total equity and reserves                            420,000

Non-current liabilities

Loan                                                                 150,000

5% Preference shares                                    40,000

Current liabilities

Payable                                                             50,000

I. Which TWO of the following statements are correct?

(1) A reduction in the tax rate will improve the interest cover ratio.

(2) If the level of long-term debt in Xen Co is reduced, the interest cover and dividend cover ratios will improve.

(3) If the level of long-term debt in Xen Co is reduced, the asset turnover ratio will improve.

(4) Financial gearing is a measure of risk, but interest cover is a measure of profitability.

II. What are the gearing ratio and interest cover for Xen Co? Place a tick in the boxes in the table below as appropriate.

A. Gearing ratio

B. Interest cover

III. Xen Co has a current ratio of 1.5 and a quick ratio of 0.9.

If cash in the bank is used to pay some of the payable, what will be the effect on the current and quick ratios?

Current ratio            Quick ratio

A                    Increase                  Decrease

B                    Decrease                  Increase

C                    Increase                  Increase

D                    Decrease                 Decrease

IV. Which of the following statement(s) is/are true?

(1) If the turnover of Xen Co increased by 20%, the asset turnover would increase by 20%.

(2) If Xen Co has a different depreciation policy to its competitors, the asset turnover ratio will not be comparable.

V. If Xen Co has a receivables to cash ratio of 2 : 2.5, what are the receivable days (to the nearest whole day)?

2. PAPER CO

Paper Co has two independent divisions, A and B. Division A produces product X. B is a new division which produces product Y. It requires units of product X to produce product Y. Last year, A sold X exclusively to the external market. Management at Paper Co did not wish to disrupt the operations of A as B was an experimental division. However, due to the success of product Y, B is now a permanent division of Paper Co. Management wants A to provide at least some units of product X to B.

The table below shows the contribution margin for each division when B purchases X from an outside supplier.

I. What would the minimum transfer price per unit of product X be if A sold 12,000 units of X, assuming that A has capacity for 15,000 units?

II. If there was no external market for product X, which of the following approaches could be used to negotiate a transfer price?

III. What would the minimum transfer price per unit of product X be if A sold 12,000 units of X, assuming that A has no spare capacity?

IV. Are the following statements about Paper Co true or false?

A. The performance of the managers of A and B will be easier to assess in an environment in which managers are able to control greater elements of the business.

B. In a competitive market, it is likely that suppliers will offer product X to Division B significantly cheaper than Division A can, for a sustained period of time.

V. Are the following two statements about Paper Co true or false?

A. Paper Co’s transfer pricing system should seek to establish a transfer price for X that will provide an incentive for the managers of A and B to make and sell quantities of products that will maximise sales of Product Y.

B. The manager of division B is likely to be more motivated if she is given freedom in which to operate and is able to purchase from outside suppliers if prices are cheaper.

3. DEEPDIV CO

Dicer is an investment centre within Deepdiv Co. Dicer has an operating profit of $30,000, and operating assets of $150,000. The cost of capital is 15%. There is a proposed investment of $15,000 which will increase the operating income by $1,900.

I. What is the residual income (RI) for Dicer with and without the proposed investment?

II. What is the return on investment (ROI) for Dicer with and without the proposed investment?

III. The divisional manager for Dicer wants to increase the ROI for the next period.

Which TWO of the following options would increase the ROI?

IV. The following statements have been made about the use of ROI as a performance measure in Deepdiv Co.

(1) If a manager’s performance is being evaluated, a portion of head office assets should be included in the calculation of ROI in Deepdiv Co’s investment centres.

(2) It may lead to short termism.

Which of the above statements is/are correct?

V. The following statements have been made about Deepdiv Co’s divisionalised structure.

(1) There is a danger that managers in the divisions may use their decision-making freedom to make decisions that are not in the best interests of the overall company.

(2) Deepdiv Co’s top management must have involvement in the day-to-day operations of the divisions.

Which of the above statements is/are correct?

4. WILLOW CO

An investment centre with capital employed of $750,000 is budgeted to earn a profit of $200,000 next year. A proposed non-current asset investment of $125,000, not included in the budget at present, will earn a profit next year of $20,000. The company’s cost of capital is 15%.

I. What is the residual income for next year, both before and after the investment is made?

A. Before investment:

B. After investment: $

II. What is the budgeted ROI for next year, both before and after the investment is made (to the nearest %)?

Before investment:

B. After investment: %

III. Are the following statements about the use of ROI in Willow Co true or false?

A. If a manager’s performance is being evaluated, a portion of head office assets should be included in the calculation of ROI in Willow Co’s investment centres.

B. If the performance of the investment centre is being appraised, head office assets or investment centre assets controlled by head office should not be included in the calculation of ROI.

IV. Are the following statements about the divisionalised structure in Willow Co true or false?

A. The authority to act to improve performance motivates the divisional managers in Willow Co, more so than if the company was centralised.

B. Willow Co’s top management must have involvement in the day-to-day operations of Willow Co.

V. Are the following statements about the use of ROI in Willow Co true or false?

A. The profit figure for ROI should always be the amount before any interest is charged.

B. The asset base of the ratio can be altered by increasing/decreasing payables and receivables (by speeding up or delaying payments and receipts).

5. SEEVER

Seever is one of a growing number of low-cost airlines in the country of Melbourne.

Seever’s strategy is to operate as a low-cost, high-efficiency airline.

The airline was given an ‘on time arrival’ ranking of seventh best by the country’s aviation authority, which ranks all 50 of the country’s airlines based on the number of flights which arrive on time at their destinations.

The average ‘ground turnaround time’ for airlines in Melbourne is 50 minutes, meaning that, on average, planes are on the ground for cleaning, refueling, etc for 50 minutes before departing again.

The number of passengers carried by the airline has grown from 300,000 passengers on a total of 3,428 flights in 2007 to 920,000 passengers on 7,650 flights in 2013.

The overall growth of the airline has been helped by the limited route licensing policy of the Melbourne government, which has given Seever almost monopoly status on some of its routes. However, the government is now set to change this policy with almost immediate effect, and it has become more important than ever to monitor performance effectively.

I. The following performance measure has been suggested for Seever:

Improve on the ‘on time arrival’ ranking of seventh best in the country’s aviation authority ratings.

To which perspective of the balanced scorecard does this measure belong?

II. The _______________ perspective considers whether the management in Seever meets the expectations of its shareholders and how it creates value for them.

Which of the following words is missing from the above statement?

III. The following performance objective has been suggested for Seever:

Increase seat revenue per plane

To which perspective of the balanced scorecard does this objective belong?

IV. The following performance objective has been suggested for Seever:

Improve the turnaround time on the ground

To which perspective of the balanced scorecard does this objective belong?

V. Are the following statements about Seever’s performance measurement system true or false?

A. When performance is not quantified, it is difficult to target and monitor.

B. Seever is more likely to have a reliable and comprehensive system for collecting data about qualitative aspects of performance than a well-established system for measuring quantitative data.

6. BERRY CO

An investment centre in Berry Co generates a profit of $24,000. You have been given the following additional information about the investment centre.

Working capital                                                                                                  20,000

Non-current assets at cost                                            230,000

Accumulated depreciation                                            170,000

Net book value                                                                                                   60,000

I. What is the ROI for the investment centre? (to the nearest %)

II. Are the following statements about the use of different performance measures in Berry Co true or false?

A. Residual income is more flexible, since a different cost of capital can be applied to investments with different risk characteristics.

B. Residual income does not facilitate comparisons between investment centres.

III. An investment in a non-current asset could be made which would result in a capital employed figure of $100,000. The investment would result in a new profit figure of $35,000 for the division. If the investment is made, what would the residual income be for the investment centre if the cost of capital is 12%?

IV. Berry Co has two divisions which are set to begin buying and selling a product between themselves. It has been suggested that a cost-based approach to transfer pricing be used.

Are the following statements about this suggestion true or false?

A. A cost-based approach is suitable for Berry Co in this scenario if an imperfect market exists.

B. A cost-based approach is suitable for Berry Co in this scenario if there is no external market for the product that is being transferred.

V. Berry Co operates a transfer pricing system between two divisions based on market price.

Are the following statements about this true or false?

A. The market price acts as an incentive to use up any spare capacity in the selling division of Berry Co.

B. Using the market price as the transfer price encourages selling and buying decisions which appear to be in the best interests of the division’s performance. This leads to the company as a whole achieving optimal results as each division optimizes its performance.

7. DEN CO

An investment centre with capital employed of $600,000 is budgeted to earn a profit of $100,000 next year. A proposed fixed asset investment of $150,000, not included in the budget at present, will earn a profit next year of $23,000 after depreciation. The company’s cost of capital is 13%.

I. What is the residual income (RI) for next year, both before and after the investment is made?

A. Before investment:

B. After investment:

II. What is the budgeted return on investment (ROI) for next year, both before and after the investment is made (to the nearest %)?

A. Before investment:

B. After investment:

III. Due to its size, Den Co operates a divisionalised structure. One of the manager’s area of responsibility is ‘decisions over costs, revenues, and assets’. The typical financial performance measures used by this manager is return on investment and residual income.

Which of the following centres best describes the manager’s responsibility area?

IV. Two of the divisional managers in Den Co disagree on the performance measure which should be used to determine their bonus for the year. Manager 1 is the manager of a large division, while manager 2 is manager of a small division. Manager 1 prefers to use residual income and has given the following examples of limitations of ROI to support this decision.

Which of the following is a valid reason for Den Co choosing to use RI and not ROI?

V. Manager 2 wishes to use ROI as a performance measure.

Which of the following reasons is a valid reason for Den Co choosing to use ROI and not RI?

8. MELCO

Melco is a large company which started as a pay-TV broadcaster and then started offering broadband and telephone services to its pay-TV customers. Customers could take advantage of discounts for ‘bundle’ packages of all three services.

All contracts to customers of Melco are for a minimum three-month period. The pay-TV box is sold to the customer at the beginning of the contract; however, the broadband and telephone equipment is only rented to them.

In the first few years after product bundling was introduced, the company saw a steady increase in profits. Then, Melco saw its revenues and operating profits fall. Several reasons were identified for the deterioration of results:

(1) In a bid to save cash, many pay-TV customers were cancelling their contracts after the minimum three-month period as they were then able to keep the pay-TV box. The box comes with a number of free channels, which the customer can continue to receive free of charge, even after the cancellation of their contract.

(2) Some bundle customers found that the broadband service that they had subscribed to did not work. As a result, they were immediately cancelling their contracts for all services within the 14-day cancellation period permitted under the contracts.

In response to the above problems and in an attempt to increase revenues and profits, Melco made the following changes to the business:

(i) It made a strategic decision to withdraw the bundle package from the market and, instead, offer each service as a standalone product.

(ii) It investigated and resolved the problem with customers’ broadband service.

It is now one year since the changes were made and the finance director wants to use a balanced scorecard to assess the extent to which the changes have been successful in improving the performance of the business.

I. Which of the following would be the most suitable measure of performance from the innovation and learning perspective in Melco’s balanced scorecard?

II. The following performance objective has been suggested for Melco:

Reduce the number of contracts cancelled due to the broadband service not working

To which perspective of the balanced scorecard does this objective belong?

III. Which of the following is most likely to be used as a measure of performance from the customer perspective in Melco’s balanced scorecard?

IV. The following performance measure has been suggested for Melco:

Volume of sales to new customers for each product/service

To which perspective of the balanced scorecard does this measure belong?

V. Melco has been advised that it could also use the Fitzgerald and Moon building block model to attempt to overcome the problems associated with performance measurement of service businesses.

Which of the following is not a building block included in this performance management system?

9. SHARK CO

Shark Co has an operating profit of $20,000, and operating assets of $95,000. The cost of capital is 12%. There is a proposed investment of $10,000 which will increase the operating profit by $1,400.

I. What is the RI with and without the proposed investment?

A. Without investment:

B. With investment:

II. What is the ROI with and without the proposed investment? (to one decimal point)

A. Without investment:

B. With investment:

III. Which of the following methods would encourage the managers of Shark Co to take a short-term view?

IV. One of the managers in Shark Co is critical of the performance measures used. She has said that they are too focused on financial performance and do not take into account any non-financial performance measures.

Are the following statements she has made true or false?

A. Financial performance measures do not necessarily provide sufficient information about ongoing problems with product quality. As a result, there is little attention paid to the generation of information on quality in Shark Co.

B. Non-financial performance indicators can give a better indication of future prospects.

V. Are the following statements about Shark Co’s divisionalised structure true or false?

A. There is a danger that managers in Shark Co may use their decision-making freedom to make decisions that are not in the best interests of the overall company.

B. A good performance measure for the divisional managers in Shark Co should include a portion of head office costs in the calculations.