Solution 13.11
 
  a) From the information on last years performance, calculate other appropriate measures or ratios in order to determine which division you consider to be the more profitable. Give your reasons and any qualifications you may have. For this part, ignore all reference to the outside supplier

 

Approach - In this question one is asked to calculate appropriate financial measures or indicators in evaluating the profitability of each division. The appropriate measures would be

  • ROCE
  • Operating profit margin
  • Capital employed turnover rates (asset turnover rates)
  • Residual income

However not all the information is given in the question to calculate these measures and thus one must extrapolate the figures from the data given to calculate the above measures.

 

Food Production

Catering

  • Actual profit is given
  • The operating profit margin or profit to sales ratio is also given at 10%. From this ratio one can calculate the sales level for each division.
  • Once sales are calculated one can calculate level of investment in the division by using the asset turnover rates given in question.
  • Once the level of investment is known then ROI can be calculated

 

  • Sales of €80m is given and an operating profit to sales percentage of 20% is also given thus operating profit is 16m.
  • As the ROCE is given at 32% and profit is calculated at €16m the level of investment can be calculated.
  • The asset turnover ratio can be calculated by simply dividing sales by the level of investment.

 

 

 

 

Food Production

 

Catering

Profit

 

€12m

20% x €80m

€16m

Sales

(€12m/10%)

€120m

 

€80 m

Profit margin

 

10%

 

20%

Asset turnover

 

2 times

(€80m / €50m)

1.6 times

Level of investment

(120m / 2)

€60m

(€16m / .32)

€50m

ROI/ROCE

(12m/60m)

20%

 

32%

Residual income

12 – (60 x 18%)

€1.2m

16 – (50 x 18%)

€7m

 

 

 

 

 

The overall return on investment is significantly higher for the catering division at 32% compared to 20% for food production. When one focuses on residual income the catering division has a residual income of €7m for an investment of €50m compared to €1.2m for food production for a level of investment of €60m.For the catering company it can be seen that it achieves a profit margin of 20% of sales double that of the food production company. However the food production company achieves a greater level of sales for its investment. This is measure by the asset turnover ratio which is 2 times for food production compared to 1.6 times for Catering. Overall the catering company is generating a greater return and even though it generates less sales per euro invested in the division it achieves a higher level of profit on those sales compared to the food production company. One should note that in the calculation of residual income using an 18% cost of capital is applied to both divisions. This implies similar risk characteristics which may not be a reasonable assumption.

 

b) Briefly examine the implications for each division and the group of the outside suppliers offer. For any numerical illustrations, you should use the figures relating to last year, assuming such a situation would also be repeated in the current year

The food production department achieves €4m profit on its sales to the catering division of €22m. This suggests the relevant costs associated with this supply is €18m. The food production department will not want to lose this business as its ROI will fall to 13.3% (12-4/60). This is below the target 18% return on investment and thus the company would achieve a negative residual income.

For the catering division if they achieve a price of €19m for the supply to an outside supplier ROI will increase to 38% (16+3/50) and RI will increase by €3m to €10m (19m – (50m x 18%)).The division must be careful to ensure the level of service from the outsider si at least equivalent to the inter-company deal.

At present the overall return for the group is 25.5% (12 +16/110) The group will lose €1m if the catering and leisure division goes outside (€19m -€18m) and the overall return for the group will fall to 24.5% (8 + 19/110). Thus the situation might be resolved by the divisions agreeing a price in the range of €19m - €20m.