Question

(ROI performance measures based on historical cost and current cost) Nature's Elixir Corporation operates three divisions that process and bottle natural fruit juices. The historical-cost accounting system reports the following information for 2018: Passion Fruit Division Kiwi Fruit Division Mango Fruit Division Revenues $1,000,000 $1,400,000 $2,200,000 Operating costs (excluding plant depreciation) 600,000 760,000 1,200,000 Plant depreciation 140,000 $260,000 Operating income Current assets 200,000 240,000 $440,000 $760,000 $ 500,000 $ 600,000 1,800,000 2,640,000 $2,300,000 $3,240,000 $ 400,000 280,000 $680,000 Long-term assets—plant Total assets Nature's Elixir estimates the useful life of each plant to be 12 years, with no terminal disposal value. The straight-line depreciation method is used. At the end of 2018, the Passion Fruit plant is 10 years old, the Kiwi Fruit plant is 3 years old, and the Mango Fruit plant is 1 year old. An index of construction costs over the 10-year period that Nature's Elixir has been operating (2008 year-end = 100) is: 2008 2015 2017 2018 100 136 160 170 Given the high turnover of current assets, management believes that the historical-cost and current-cost measures of current assets are approximately the same. REQUIRED 1. Compute the ROI ratio (operating income to total assets) of each division using historical-cost measures. Comment the results 2. Compute the ROI of each division, incorporating current cost estimates as of 2018 for depreciation expense and long-term assets. Comment on the results. 3. What advantages might arise from using current-cost asset measures as compared with historical cost measures for evaluating the performance of the managers of the three divisions?

Answer 1

Answer

1) ROI using historical cost measures:

ROI = Operating Income/Total assets

Passion Fruit = $260,000 ÷ $ 680,000 = 38.24%

Kiwi Fruit = $440,000 ÷ $2,300,000 = 19.13%

Mango Fruit = $760,000 ÷ $3,240,000 = 23.46%

The Passion Fruit Division appears to be considerably more efficient than the Kiwi Fruit and Mango Fruit Divisions.

2) ROI using Current cost measures:

The gross book values (i.e., the original costs of the plants) under historical cost are calculated as the useful life of each plant (12 years) × the annual depreciation:

Passion Fruit = 12 × $140,000 = $1,680,000

Kiwi Fruit = 12 × $200,000 = $2,400,000

Mango Fruit = 12 × $240,000 = $2,880,000

Step 1:

Restate long-term assets from gross book value at historical cost to gross book value at current cost as of the end of 2018:

(Gross book value of long-term assets at historical cost) × (Construction cost index in 2011 ÷ Construction cost index in year of construction).

Passion Fruit = $1,680,000 × (170 ÷ 100) = $2,856,000

Kiwi Fruit = $2,400,000 × (170 ÷ 136) = $3,000,000

Mango Fruit = $2,880,000 × (170 ÷ 160) = $3,060,000

Step 2:

Derive net book value of long-term assets at current cost as of the end of 2018. (Estimated useful life of each plant is 12 years.)

(Gross book value of long-term assets at current cost at the end of 2018) × (Estimated remaining useful life ÷ Estimated total useful life)

Passion Fruit = $2,856,000 × ( 2 ÷ 12) = $ 476,000

Kiwi Fruit = $3,000,000 × ( 9 ÷ 12) = $2,250,000

Mango Fruit = $3,060,000 × (11 ÷ 12) = $2,805,000

Step 3:

Compute current cost of total assets at the end of 2018.(Assume current assets of each plant are expressed in 2018 dollars.)

(Current assets at the end of 2018 [given]) + (Net book value of long-term assets at current cost at the end of 2018 [Step 2])

Passion Fruit = $400,000 + $ 476,000 = $ 876,000

Kiwi Fruit = $500,000 + $2,250,000 = $2,750,000

Mango Fruit = $600,000 + $2,805,000 = $3,405,000

Step 4:

Compute current-cost depreciation expense in 2018 dollars.

Gross book value of long-term assets at current cost at the end of 2011 (from Step 1) ÷ 12

Passion Fruit = $2,856,000 ÷ 12 = $238,000

Kiwi Fruit = $3,000,000 ÷ 12 = $250,000

Mango Fruit = $3,060,000 ÷ 12 = $255,000

Step 5:

Compute 2018 operating income using 2018 current-cost depreciation expense.

(Historical-cost operating income– [Current-cost depreciation expense in 2018 dollars (Step 4) – Historical-cost depreciation expense])

Passion Fruit = $260,000 – ($238,000 – $140,000) = $162,000

Kiwi Fruit = $440,000 – ($250,000 – $200,000) = $390,000

Mango Fruit = $760,000 – ($255,000 – $240,000) = $745,000

Step 6:

Compute ROI using current-cost estimates for long-term assets and depreciation expense.(Step 5 ÷ Step 3).

Passion Fruit = $162,000 ÷ $ 876,000 = 18.49%

Kiwi Fruit = $390,000 ÷ $2,750,000 = 14.18%

Mango Fruit = $745,000 ÷ $3,405,000 = 21.88%

ROI: Historical Cost ROI:Current Cost

Passion Fruit 38.24% 18.49%

Kiwi Fruit 19.13% 14.18%

Mango Fruit %23.46 21.88%

Use of current cost results in the Mango Fruit Division appearing to be the most efficient. The Passion Fruit ROI is reduced substantially when the ten-year-old plant is restated for the 70% increase in construction costs over the 2008 to 2018 period.

3) Advantages of current cost asset measures :

Use of current costs increases the comparability of ROI measures across divisions’ operating plants built at different construction cost price levels.

Use of current cost also will increase the willingness of managers, evaluated on the basis of ROI, to move between divisions with assets purchased many years ago and divisions with assets purchased in recent years.