Page 96 - DMGT514_MANAGEMENT_CONTROL_SYSTEMS

Unit 4: Responsibility Centers

If sales are restricted to outside sales only, there is reduction in net profit of ` 35,000 (` 1,65,000 – Notes
` 1,30,000) and reduction of ROI from 13.75% to 13.0%, hence, the proposition of the manager of
division A is not correct from company’s overall point of view.
Problem 7: The ABC company has three divisions - A, B and C. Division A is exclusively a
marketing division. Division B is exclusively a manufacturing division and Division C is both
a manufacturing and marketing division. The following are the financial facts of each of these
divisions:

Division A Division B Division C
Current assets ` 1,00,000 ` 1,00,000 ` 1,00,000
Fixed assets - 10,00,000 5,00,000
Total assets 1,00,000 11,00,000 6,00,000
Profits before dep. & mktg. Dev. Costs 2,00,000 2,00,000 2,00,000

Required: Assume that the ABC company depreciates fixed assets on a straight line basis over 10
years. To maintain its markets and productive facilities, it has to invest ` 1,00,000 per year in
market development in division A and ` 50,000 per year in division C. This is written off as an
expense. It has to replace 10% of its productive facilities each year. Under these equilibrium
conditions, what are the annual rates of return earned by each of the division?
Solution:
Divisions
A B C Total
Profit before dep. & mktg. Dev. Costs 2,00,000 2,00,000 2,00,000 6,00,000
Less: Depreciation - 1,00,000 50,000 1,50,000
Less: Market development costs 1,00,000 - 50,000 1,50,000
Net profit 1,00,000 1,00,000 1,00,000 3,00,000
Total assets 1,00,000 11,00,000 6,00,000 18,00,000
ROI = _Net profit x 100 100% 9.1% 16.7% 16.7%
Total assets

Note: Since depreciation on fixed assets is 10% and company is replacing 10% of its productive facilities
every year, fixed assets figure will remain the same from year to year.
Problem 8: The G division of the GHI Corporation proposes the following investment in a new
product line:
Investment in fixed assets ` 1,00,000
Annual profits before depreciation but after taxes ` 25,000 (i.e., annual cash flow)
Life 5 years

The GHI Corporation used the time adjusted rate of return, with a cut-off rate of 8% in evaluating
its capital investment proposals. A ` 25,000 cash in flow for five years on an investment of
` 1,00,000 has a time adjusted return of 8%. Consequently, the proposed investment is acceptable
under the company’s criterion. Assume that the project is approved and that the investment and
profit were the same as estimated. Assets are included in the divisional investment base at the
average of the beginning of the years net book value.
Required: Calculate the rate of return that is earned by the G division on the new investment for
each year and the average rate for the five years, using straight line depreciation.

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