Question

ABC manufactures door frames which it supplies mostly to house builders. The board of Jack is thinking of implementing a Balanced Scorecard (BSC) to help it manage its strategic performance. Detailed below are the financial performance measures currently used and the Board are looking for your help in the calculation of Residual Income (RI) and Return on Capital Employed (ROCE).

	Y/E 31/12/2019	Y/E 31/12/2018
	$000	$000
Revenue	510	543
Cost of sales	320	300
Gross profit	190	243
Other operating costs	99	90
Operating profit	91	153
Finance cost	26	20
Profit before tax	65	133
Tax	11	27
Profit after tax	54	106
Non-current assets	640	530
Current assets	380	325
Current liabilities	45	32
Non-current liabilities	190	100
WACC	9%	9%

Jack is also considering an investment to enhance production. This investment will shorten production time and reduce costs by the use of digital technology. The investment will have a useful life of four years, after which it will have a scrap value of $0. The financial details on this investment are listed below:

Investment:

Initial cost                                      $86.4 million

Net cash inflow                            $30 million per annum

Cost of capital                              9%

Depreciation policy                              Straight line

For information:

ROI is calculated using controllable profit. Controllable profit is calculated as net cash flows less depreciation.

For future planning purposes, ROI and Residual Income (RI) are calculated using the opening written down value of plant and licence assets in each year.

The Net Present Value (NPV) for the investment is positive.

                       

Required:

1. Calculate the Return on Capital Employed (ROCE) and the Residual Income (RI) for Mars for the year end December 2019 period.  

2. Prepare a summary schedule for the proposed investment for each of the four years ending 31^st December 2020 to 31^st December 2023 which shows the estimated value of:
   1. Controllable Profit per annum
   2. Residual income for years 1,2,3 and 4
   3. Return on Investment for years 1,2,3 and 4

3. Identify one performance measure for each of the four categories of the Balanced Scorecard (BSC): Financial, Internal, Learning and Growth and Customers.

4. Explain why two of the measures you identified in part c) above are appropriate for Jack.

5. Discuss the nature of “cause and effect” in the BSC as it relates to your suggestions in part d) above.

Answer 1

(a) Return on Capital Employed
= (Earnings before Interest & Tax/Capital Employed) * 100
where, Earnings before Interest & Tax = Operating Profits
where, Capital Employed = Total Assets - Current Liabilities
Non-current assets			640.00
Current assets			380.00
Total assets			1,020.00
Less: Current liabilities			45.00
Capital employed			975.00
Earning before Interest & Tax			91
Return on Capital employed = (91/975)*100
= 0.0933 *100
= 9.33%
Residual Income = Operating Profits - (WACC * Average Capital Employed)
where,Operating Profits			91.00
WACC			9%
Average Capital Employed
= (Opening Capital Employed + Closing Capital Employed)/2
			Opening Capital Employed	Closing Capital Employed
Non-current assets			530.00	640.00
Current assets			325.00	380.00
Total assets			855.00	1,020.00
Less: Current liabilities			32.00	45.00
Capital employed			823.00	975.00
Average Capital Employed = (823+975)/2
= 1798/2
= 899
Residual Income = 91 - ( 9% * 899)
= 91 - 80.91
= 10.09
(b)
Computation of Depreciation
Initial Cost		86.40
Less: Scrap Value		-
Depreciable Value		86.40
Useful Life		4.00
Annual Depreciation = Depreciable Value/Useful Life
= 86.40/4
= 21.60
Controllable Profits per annum arising due the asset
= Net cash inflow - Depreciation
= 30 - 21.60
= 8.40
(i) Computation of Controllable Profits per annum
= Controllable Profits per annum before the usage of asset + Controllable
Profits arising due to the asset
= 91 + 8.40
= 99.40
(ii) Residual Income = Operating Profits - (WACC * Capital Employed)
			Year 1	Year 2	Year 3	Year 4
Operating Profits			99.40	99.40	99.40	99.40
Computation of Capital Employed
			Year 1	Year 2	Year 3	Year 4
Non-current assets			640.00	640.00	640.00	640.00
Add:WDV of asset purchased			64.80	43.20	21.60	-
Current assets			380.00	380.00	380.00	380.00
Total assets			1,084.80	1,063.20	1,041.60	1,020.00
Less: Current liabilities			45.00	45.00	45.00	45.00
Capital employed			1,039.80	1,018.20	996.60	975.00
Capital employed			1,039.80	1,018.20	996.60	975.00
WACC			9%	9%	9%	9%
WACC * Capital employed			93.58	91.64	89.69	87.75
Residual Income			5.82	7.76	9.71	11.65
(iiI) Return on investments = (Net Profit/Opening Capital Employed)*100
Computation of Net Income
			Year 1	Year 2	Year 3	Year 4
Net income before purchase of asset			54.00	54.00	54.00	54.00
Add:Income arising due to purchase of asset			8.40	8.40	8.40	8.40
Net income			62.40	62.40	62.40	62.40
			Year 1	Year 2	Year 3	Year 4
Non-current assets			640.00	640.00	640.00	640.00
Add:WDV of asset purchased			64.80	43.20	21.60	-
Current assets			380.00	380.00	380.00	380.00
Total assets			1,084.80	1,063.20	1,041.60	1,020.00
Less: Current liabilities			45.00	45.00	45.00	45.00
Capital employed			1,039.80	1,018.20	996.60	975.00
Net income			62.40	62.40	62.40	62.40
Capital employed			1,039.80	1,018.20	996.60	975.00
Return on investments = (Net Profit/Opening Capital Employed)*100			6.00%	6.13%	6.26%	6.40%
(c.) Identification of performance measures for each category of BSC
Category		Performance Measure
Finance		Cash Flow Increase in ROI
Internal		Product Cycle Time Unit Cost
Learning & Growth		New Product Introduction
Customer		On-time delivery
(d) The following two performance measures are appropriate for Jack
Increase in ROI (Finance) - The return on investments which was 5.54% in 2019 has
shown a consistent year on year increase after the purchase of the new asset.It has
increased from 6% in year 1 to 6.40% in year 4
Product Cycle Time (Internal) - The purchase of the new asset has resulted in shortening
of the production time which results in increase in quantity available to the company for
sale to the customers as well as reducing the unit cost of the product because the
fixed costs are spread over a higher quantity of products. This increase in efficiency
results in reduction of costs and increasing operating profits.
(e.)
The " cause and effect" model in balanced score card approach is used to describe as
to how a strategy will create change.The cause and effect model is captured by
identifying an objective and then creating a strategy map to achieve that objective.
Increase in ROI (Finance) - The cause for this performance measure is to increase the
returns on the investments made by the shareholders.The strategy adopted is to
increase the operating profits which would result in higher returns on investments.
Product Cycle Time (Internal) - The cause for this performance measure is achieving
customer satisfaction.The strategy adopted is to reduce the lead time for its customers
by reducing the product cycle time by purchasing a new asset which reduces the
product cycle by adopting digital technology