Question

1. Omega Inc. is a large business with several divisions, including Delta Division.  Omega’s headquarters and the majority of its operations are located in Canada, and are concentrated in natural resource extraction and chemical production. The Delta Division is located in Luxembourg and is a manufacturer of luxury soaps and other products aimed at the high-end retail market.  Omega has a company-wide ROI of 14% and pays bonuses based on divisional ROI.  The before-tax required rate of return on assets for all divisions of Omega is 10%.

Delta Division has reported the following results for 2019:

Sales revenue	$380,000
Variable costs	$220,000
Fixed costs	$125,000
Total operational assets	$150,000

Delta is considering adding a new product line.  Projected data for this product line are as follows:

Sales revenue	$73,500
Variable costs	$45,000
Fixed costs	$21,250
Total operational assets	$39,500

20       Required:

1. Based on the information provided above, what type of responsibility centre is the Delta Division?  Explain how this was determined.
2. Calculate the ROI of the new product line.
3. Determine the effect of the new product line on Delta’s ROI. Would Delta’s managers be encouraged to introduce the new product line.
4. What impact would the new project have on Omega’s ROI?  There is not enough information to calculate the new ROI, but there is enough to determine the direction of the change.  Will top management of Omega want to have the product introduced?
5. Calculate the residual income of the Delta Division before and after the new product is added.  Would the Delta Division’s managers be encouraged to introduce the new product if performance was measured using residual income?  Explain.
6. Describe the advantages of using residual income as a performance measure instead of using ROI. Why would Omega choose ROI, given the advantages just described?
7. The decision as to whether or not to delegate decision-making authority is influenced by the type of knowledge required to make decisions.  Evaluate whether Omega should delegate decision-making authority to the managers of Delta Division.   

Answer 1

Particulars Sales revenue (A) Variable Cost Contribution Fixed Costs Profit (B) Delta 3,80,000 2,20,000 1,60,000 1,25,000 35,000 New 73,500 45,000 28,500 21,250 7,250 Combined 4,53,500 2,65,000 1,88,500 1,46,250 42,250 Total Operational Assets (C) 1,50,000 39,500 1,89,500 ROI (B/C) 23.33% 18.35% 22.30% Net Profit Ratio (B/A) 9.21% 9.86% 9.32%

a.

Investment center.

The reason for selecting Delta Division as the Investment center is because as we can see, the company wide ROI is fixed at 14% and the minimum required before tax ROI for each department is 10%. But for the Delta division, we can see that ROI is 23.33% at the present situation. This indicates that the Delta division is operating at a very high level of ROI and is generating a higher level of profits for the company. Also, since the division is operating in the luxury category, the company can't sacrifice on the cost of production as the customers won't sacrifice on the quality due to cost cutting techniques. Again, being in the luxury brand segment, the amount of investment that is made on this department will also be higher and the company must be treating it as an investment center.    

b.

As shown in the above table, the before tax ROI of new product line is 18.35%.

ROI (before tax) = Profit before Tax/ Total Operational Assets * 100

c.

As shown in the above table, the combined ROI of Delta division after the new product is launched will be 22.30%.

When we look at this from the perspective of Delta's managers, they WONT be encouraged to introduce the new product as the ROI of the company is falling post launch of the new product. And also, it is mentioned that the company has the policy of paying bonuses based on the divisional ROI and hence, lowering the ROI of the division won't be accepted by the managers of the division. Therefore I think that the managers won't be encouraged to introduce the new product.

d.

As we can see that the ROI of the new product line would be 18.35% and it is mentioned in the question that the company wide ROI of Omega is only 14%. As we can see that the new product line is offering a higher level of ROI. This shows that the introduction of the new product line would impact an increase in ROI of Omega Inc as a whole.

Hence I believe that the top management would be really interested in launching the new product for the company as they target the overall growth of the company rather that the higher return generated by a single division.

e.

From the table above, the residual incomes are as follows:

Residual Income before Introduction of new product:   $ 35,000.00

Residual Income after Introduction of new product: : $ 42.250.00

Here we can see that the residual income of the Delta division has increased on introduction of new product line. Also, if we see the Net profit ratio of the Delta division from the table above, before and after introduction of the product, we can see that the overall profitability of the division has increased from 9.21% to 9.32%. This also indicates that the profitability of the division has increased due to increase in the residual income of the division before and after introduction of the new product.

Hence, if performance was measured using residual income, the Delta Division's managers WILL be encouraged to introduce the new product line.

f.

Advantages of Residual Income approach:

• Residual income valuation is suitable for mature companies that do not give out dividends or follow unpredictable patterns of dividend payments. In this regard, the residual income model is a viable alternative to the dividend discount model (DDM).   
• It works well with companies that do not generate positive cash flows yet.
• It encourages investment centre managers to make new investments if they add to RI. A new investment might add to RI but reduce ROI. In such a situation, measuring performance by RI would not result in dysfunctional behaviour, i.e. the best decision will be made for the business as a whole.
• Making a specific charge for interest helps to make investment centre managers more aware of the cost of the assets under their control.

The main reason for Omega Inc to select ROI is that ROI shows a much better picture about the performance of the company as a whole considering various other factors as well other that profit. May be some products will be making high amount of profits, but, it would be incuring a higher level of investment as well. So ROI shows a clear picture about the level of income generated with a given amount of investment. This helps in better comparison with similar companies operating within the same industry as the level of investment made by different companies within the same industry is different and hence, it won't be logical to make comparison between them with the amount of profit generated by them.
Therefore, to get a more clear picture of the overall performance of the company over and above profit generated by it and for better comparison with competing firms in the industry Omega Inc has considered ROI as the evaluation measure.