- 15 Marks
MA – L1 – Q61 – Performance analysis
Question
Keta Textiles Ltd is planning to open a new investment centre, which will make and sell a single product. The investment in the new division at the beginning of the year will be GH¢2 million, consisting entirely of non-current assets. These are expected to have a five-year life with no residual value, and they will be depreciated each year at the rate of 20% of cost.
Sales in the first year of operation are expected to be GH¢4 million and the budgeted gross profit is 30%. Overhead costs excluding depreciation of non-current assets will be GH¢600,000 in Year 1.
The estimates for the first five years of operation are as follows:
(1) The company will not make any additional investment in non-current assets for the division in the first five years.
(2) The cost of sales per unit in the five years will remain constant, with no increases.
(3) Sales volume will be the same in Year 2 as in Year 1. Sales volume will then increase in Year 3 by 5% but will fall by 10% in Year 4 and a further 10% in Year 5.
(4) The sales price per unit will be increased by 5% in Year 2. There will be no change in sales prices in Year 3, but prices will be increased by 5% in Year 4 and again by 5% in Year 5.
(5) Overhead costs excluding depreciation will remain at GH¢600,000 for the first three years, but will then be GH¢700,000 in each of Years 4 and 5.
Required:
Calculate the return on investment for the division for each of the first five years, assuming that ROI is calculated using the net book value of assets at the beginning of the year.
Using ROI and any other measures of performance, assess the expected performance of the division over the five-year period.
Answer
Sales revenue
Year 2: GH¢4.0 million × 1.05 price increase = GH¢4.2 million
Year 3: GH¢4.2 million × 1.05 volume increase = GH¢4.41 million
Year 4: GH¢4.41 million × 0.90 × 1.05 = GH¢4.17 million
Year 5: GH¢4.17 million × 0.90 × 1.05 = GH¢3.94 million
Cost of sales
Year 1: GH¢4.0 million × (100-30)% = GH¢2.8 million
Year 2: No volume change; therefore same as in Year 1
Year 3: GH¢2.8 million × 1.05 volume change = GH¢2.85 million
Year 4: GH¢2.85 million × 0.90 volume change = GH¢2.565 million
Year 5: GH¢2.565 million × 0.90 volume change = GH¢2.39 million
Annual depreciation = GH¢2 million × 20% = GH¢400,000.
Investment
Year 1: GH¢2.0 million
Year 2: GH¢1.6 million
Year 3: GH¢1.2 million
Year 4: GH¢0.8 million
Year 5: GH¢0.4 million
| Year | 1 | 2 | 3 | 4 | 5 |
|---|---|---|---|---|---|
| GH¢000 | |||||
| Sales | 4,000 | 4,200 | 4,410 | 4,170 | 3,940 |
| Cost of sales | 2,800 | 2,800 | 2,850 | 2,565 | 2,390 |
| Gross profit | 1,200 | 1,400 | 1,560 | 1,605 | 1,550 |
| Overheads | 600 | 600 | 600 | 700 | 700 |
| Depreciation | 400 | 400 | 400 | 400 | 400 |
| Profit | 200 | 400 | 560 | 505 | 450 |
| Investment | 2,000 | 1,600 | 1,200 | 800 | 400 |
| ROI | 10% | 25% | 46.7% | 63.1% | 112.5% |
Performance evaluation
ROI increases over the five years from 10% to 112.5%. This increase occurs because the net book value of the non-current assets declines each year due to depreciation, but the profit remains fairly strong, particularly in Years 3, 4, and 5. The increase in ROI does not necessarily mean that the division’s performance is improving, because the investment base is declining.
Sales revenue increases in Years 2 and 3 due to a price increase in Year 2 and a volume increase in Year 3. However, sales revenue declines in Years 4 and 5 due to reductions in sales volume, in spite of price increases. The gross profit margin increases from 30% in Years 1 and 2 to 35.4% in Year 3, 38.5% in Year 4, and 39.4% in Year 5, due to the sales price increases.
Profit increases from GH¢200,000 in Year 1 to a peak of GH¢560,000 in Year 3, but then declines to GH¢450,000 in Year 5. The decline in Years 4 and 5 is due to a fall in sales volume and an increase in overhead costs to GH¢700,000 in each of Years 4 and 5.
The division’s performance appears to be fairly good in the first three years, but the fall in sales volume in Years 4 and 5, combined with higher overhead costs, is a matter for concern. Management should investigate the reasons for the expected fall in sales volume, and take action to prevent the decline.
- Uploader: Salamat Hamid