Question

Question 2

JK Building Equipment Ltd is a Windhoek based company tha supplies buibing aquipment. the company has a policy of measuring the two divisions it has using residual income. the following figures relate to the two divisions for the year ended 31st December 2017.

                                                                                                                Division A                   Division B

                                                                                                                     $                                 $

Sales                                                                                                        30 000 000                  11 000 000

Divisional variable costs                                                                              17 000 000                    5 000 000

Division fixed costs                                                                                       4 000 000                    4 000 000

Division contribution to corporate profits                                                   8 800 000                     2 000 000

Allocation of corporate fixed costs                                                                  3 400 000                       900 000

Division profit                                                                                              5 400 000                    1 100 000

The cost of capital in both divisions is 18% and taxation is ignored for the purpose of performance evaluation. The net book value of non-current assets is used in determining the residual income. The extract from the statement of financial position relate to the two divisions as at 31 December 2017:

                                                                                          Division A                         Division B

                                                                                                $                                     $

Non current assets(net book value)                                         25 000 000                       10 000 000

Current assets                                                                      18 000 000                         5 000 000

Cerrent liabilities                                                                      6 500 000                        2 800 000

Division A incurred $600 000 in advertising expenditure to promote brand image while by Division B spent $840 000 for the same purpose. It is expected that both divisions will benefits from this expenditure commercially in the year 2017 to 2020 inclusive.

In the years 2016 and 2017, Division B spent significant amounts on research and development which were written off as divisional fixed costs in the year of expenditure because they were not meeting the definition of intangible assets as required by IAS 38.The amounts were $900 000 in 2016 and $2 250 000 in 2017.The manager for Division Bis of the opinion that the accounting treatment adopted is correct for reporting externally but does not think it should be used to measure the performance of his division.He believes these expenditures are an investment in which future economic benefits will flow to the division for the next six years. Division A didn't incur reasonable costs in research and development in the years 2016 and 2017.

Division Brelies heavily on delivery vevicles. JK Building Equipment Ltd had the capacity to purchase these vehicles but the divisional manager opted to lease them instead using a short term arrengement that is renewed on an on-going basis. This arrangement resulted in divisional fixed costs of $400 000 incurred as lease rental instalments. If these vehicles were purchased, they could have been having a carrying amount of $2 000 000 at 31 December 2017 after deducting the current year depreciation of $250 000.

Requirement:

a) Compute the Residual income (RI) of each division for 2017             

b) Compute the Economic Value Added (eva) of each division for 2018  

c) Using the information about Division A and Division B to illustrate your answer, should JK use RI or EVA in evaluating performance of these two divisions ( 9 marks)

Answer 1

a)calculation of residual income:    division A division B

OPERATING INCOME(W.N 1) 4800000 260000

LESS: CAPITAL EMPLOYED*COST OF CAPITAL (W.N 2) 6570000 219600

RESIDUAL INCOME (1770000) 404000

W.N1:

DIVISION PROFIT 5400000 1100000

LESS:ADV.EXPENSE 600000 840000

OPERATING INCOME 4800000 260000

research and development expense and lease rent payemnt are to be capitalised and not debited in profit account

CAPITAL EMPLOYED    A B

NON CURRENT ASSETS   25000000 10000000

CURRENT ASSETS 18000000 5000000

LESS:CURRENT LIABILITIES (6500000) (2800000)

CAPITAL EMPLOYED 36500000 1220000 COST OF CAPITAL 18% 18%

6570000 2196000

B)EVA =NOPAT-(CAPITAL EMPLOYED*COST OF CAPITAL)

as NOPAT=operating income*(1-tax rate), here tax is nil the NOPAT = OPERATING INCOME

SO, THE EVA shall be same as residual income