Measuring Performance
NZ Lawn Care Ltd sells a range of garden tools and fertilisers. Due to the differences in the market segments that they cater for, both garden tools and the fertilizer division operate independently, where divisional managers are responsible for investment and operating decisions of their own divisions. The performances of managers are evaluated against the target return on investment (ROI) of the company which is set at 10% and by the residual income (RI) each division generates. Managers who exceed this target are rewarded with a bonus.
The following financial information relates to the divisional performance for the year ended April 2012.
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Garden tools($)
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Fertiliser($)
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Operating profit
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1,356,000
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1,840,500
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Sales revenue
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8,475,000
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10,225,000
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Invested capital
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16,950,000
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20,450,000
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During the last financial year, both divisions were severely affected by the global economic downturn and the managers have suggested the following strategies to overcome the problem:
- The manager of the Garden tools division proposes to cut the work force by 10% by which the division's operating expenditure can be reduced by 30% without sacrificing sales revenue. In addition, he also hopes to implement a Just-in-time (JIT) system for inventories which would reduce the capital invested in the division by $2,500,000.
- The manager of the Fertiliser division reckons that the main problem with his division is the lack of sales volume due to the stiff competition that it faces. He proposed to acquire a competitor, paying $10,000,000 to consolidate the market and to increase sales. The following are the financial data pertaining to the competitor:
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Competitor ($)
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Operating profit
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980,000
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Sales revenue
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8,000,000
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In addition, both managers expressed their dissatisfaction over the company's preference to evaluate their performance based on ROI and RI. They argue that an approach based on economic value added (EVA®) would provide a better measure.
Required:
1. Compute the ROI for both divisions showing the return on sales and investment turnover for the year ended April 2012.
2. Evaluate the impact that the proposed strategies would have on ROI and RI for each division assuming that NZ Lawn Care Ltd's minimum required rate of return is 9%. (In each instance show the return on sales and investment turnover). Comment also on the validity of adopting the strategies in the short and long term.
3. Explain why EVA is considered a superior performance evaluation method in comparison to ROI and RI?