1

Chapter 10
Control in Divisionalized Organizations
Answer to End of Chapter Exercises

Q 10.1
Division A Division B
a) '000 '000
Profit 480 130
CA 280 400
FA 1840 2200
2120 2600
ROI % 22.6% 5.0%

Evaluation of the two project using net present value

Project
X Project Y
Cash Present Cash Present
Year flow value Year flow value
-
0 200,000 1 -200,000 0 -500,000 1 -500,000
1 36,000 0.8696 31,304 1 140,000 0.8696 121,739
2 36,000 0.7561 27,221 2 140,000 0.7561 105,860
3 36,000 0.6575 23,671 3 140,000 0.6575 92,052
4 236,000 0.5718 134,934 4 140,000 0.5718 80,045
5 140,000 0.4972 69,605
17,130 -30,698

Project X delivers a postive net present value of 17,130 and is worthwhile, while project Y
delivers a negative net present value of 30,698 and is not worthwhile.

1) Project X '000 Project Y '000

Contribution from
sales 120 Contribution 140
less advertising 84 less depreciation 100
Additional profit
p.a. 36 Additional profit p.a. 40
Investment 200 Investment 500
ROI % 18% ROI % 8%

Project X provides a positive net present value and so should be accepted but reduces
the overall ROI of the division

Project Y provides a negative net present value and so should be rejected but increases
the overall ROI of the division

b) Head office would accept project X, but not Y. Divisional manager B might be tempted to
progress with project Y.

c) A range of options are available

- Investment decisions could be removed from divisional managers

2008 John Wiley & Sons Ltd.

www.wileyeurope.com/college/bowhill
 2

- Consider a change in the measurement system. In this chapter the possible use of
residual income as an alternative measure has been introduced. Note that a broader
range of measures are discussed in much greater detail in part 4 of this book.

d) See chapter
Residual income before
e) i) the investment Division A Division B
'000 '000
Net profit 480 130
Interest charge @15% 318 390
162 -260

e) ii) Residual income of investment

Residual income including the investment

Division A Division B
'000 '000
Net profit 516 170
Interest charge @15% 348 465
168 -295

Workings (residual income of projects)

Project X Project Y
'000 '000
Profit from investment 36 40
Interest charge (200,000 @ 15%) 30 500,000@15% 75
Residual income of divisions after the
investments 6 -35

Q 10.2
Fairdoo B division Cheapbuy

Price 90 95 85
contribution from division c 16
additional cost to company 74

a) Cheapest from division A managers viewpoint is Cheapbuy.

b) From Aldo Ltd's perspective the best option is to buy from Fairdoo as the additional cost to the
company is 74. 90 to purchase the component less 16 contribution earned by Division C which
is not operating at full capacity.
c) Could introduce some method for sharing the contribution earned e.g. dual pricing or negotiated price.

2008 John Wiley & Sons Ltd.

www.wileyeurope.com/college/bowhill
 3

Q 10.3 a) It is necessary to compare the cost of buying in against the cost of making.
i) The quote from Apple Ltd is 7,200, but division C will undertake work for Apple Ltd and will receive a
contribution from this work. Since division C is not operating at full capacity, this contribution should be
taken into consideration
Apple

7,200
less contribution division C (Note 1)* 600
Cost to company 6,600

* (Note 1)calculation of contribution to division C

Sales 2,000
variable cost 1,400
Contribution to division C. 600

ii) If the quote is given to division B, in order to calculate the cost to the company it is necessary to
identify whether the relevant cost of work completed by divisions C and D should be included
at variable cost or at market price.
Division B

Quoted price 9,200
mark-up 2,300
Costs to division B 6,900
less cost of component from division C 2,000
4,900
less cost of work sub-contracted to division D 2,700
Variable cost of division B 2,200

If there is spare capacity in divisions B, C and D then the additional cost to division B is
Variable cost of division B 2,200
Variable cost of division C 1,400
Variable cost of division D** (Note 2) 1,350
4,950
Additional cost to the company of manufacturing in division B if there is spare capacity in those
divisions as well as division C is 4,950.
The cost to the company of buying in from Apple is 6,600. It is therefore in the interests of the organisation
to manufacture the component internally.

Divison D** (Note 2)

Sales 2,700
Variable cost 1,350
Contribution 1,350

b) If there is no spare capcity in division D then there is an opportunity cost of 1,350 i.e.
the relevant cost of using division D is the market price of 2,700. So relevant cost of Division B undertaking
the work is
Variable cost of division B 2,200
Variable cost of division C 1,400
relevant cost of division D 2,700
6,300
The relevant cost of 6,300 is still less than the cost of purchasing from Apple ltd so from a company
perspective it is still better to purchase from Division B

2008 John Wiley & Sons Ltd.

www.wileyeurope.com/college/bowhill
 4

Q 10.4
a)i) '000 '000
Profit 450
CA 575
FA 525
1100
ROI % 40.9%

aii) - Investment in machine of 240,000.

Machine will provide a saving of 70,000 per annum. Depreciation is 40,000 per
annum so the favourable impact on profit is 30,000 p.a. Net book value at the end
of the year on the asset is 240,000 - 40,000 = 200,000
Original add New
'000 '000 '000
Net
profit 450 30 480
Net capital
employed 1,100 200 1300
R.O.I
% 40.9% 15.0% 36.9%

aii) discount to customers

Original add New
'000 '000 '000
Net
profit 450 -0.96 449.04
Net capital
employed 1,100 -36 1064
R.O.I
% 40.9% 2.7% 42.2%

aii) sell machine

Original add New
'000 '000 '000
Net
profit 450 -20 430
Net capital
employed 1,100 0 1100
R.O.I
% 40.9% 39.1%

b) Decision on investment in new machine

The divisional manager may be against the decision to invest in the new machine
costing240,000 as there is a reduction in the ROI %age in the year. Reviewing the
investment (see table below) there appears to be a substantially positive net present
value generated and accordingly it is likely that head office would welcome the
investment.

Machinery
Year Cash flow Present value
'000 '000
0 -240 1 -240
1 70 0.8772 61

2008 John Wiley & Sons Ltd.

www.wileyeurope.com/college/bowhill
 5

2 70 0.7695 54
3 70 0.6750 47
4 70 0.5921 41
5 70 0.5194 36
6 70 0.4556 32

Net present value +32

Decision on offering discount

The divisional management may be for the decision as it results in a higher ROI

The interest saving on reduced trade receivables is 36,000 x 14% = 5,040.

The cost reduction is 6,000 so the impact on the profit of the organisation is
adverse.

Decision on sale of machine

The impact of selling the machine now would be to have an adverse impact on ROI.

Selling the asset for 40,000 would result in a loss of 60,000 (sale price of 40,000
- depreciation 100,000).
If the asset was kept the impact would be a loss of 40,000 (contribution 60,000
- depreciation 100,000
Both Head office and divisional managers would be against the decision.

2008 John Wiley & Sons Ltd.

www.wileyeurope.com/college/bowhill
 6

Q 10.5
Cash Discount
a) Year flow factor Present value
'000 '000
0 -50 1 -50
1 5 0.9091 5
2 10 0.8264 8
3 10 0.7513 8
4 25 0.6830 17
5 25 0.6209 16

Net present value 3

ARR is 10% and in the first year it is 0%. NPV is +ve but
given an ARR less than the target ROI, Jack Jones may not
be keen to undertake the investment.

b) April June 20X8

Total Sales 598,000
Less variable costs:
Labour 211,558
Material 143,240
Controllable contribution 243,202
Less controllable divisional expenses
Fixed Production overhead 132,000
Accounting 35,000
Commercial 23,000
Controllable profit 53,202
Allocation of corporate advertising 20,000
Divisional net profit 33,202

2008 John Wiley & Sons Ltd.

www.wileyeurope.com/college/bowhill