Reference no: EM132480554

Riverside Mining and Manufacturing is a vertically integrated company that mines, processes, and finishes various non-precious metals and minerals. Riverside has decentralized both on a geographical and on an operational basis. For example, Exploration and Development, which includes all mining operations, has been designated a strategic business unit (SBU). There are multiple divisions within this SBU, such as North American Exploration and Development, South American Exploration and Development, and other divisions. Similarly, Refining, which has often been located near the mines, is another strategic business unit and is divisionalized by geographical region.

Riverside has a clearly stated management control system that includes longstanding policies on transfer pricing, performance evaluation, and management compensation. Transfers are made at full cost plus a markup to approximate net realizable value. Riverside's primary operating divisions (such as mining) are required to fill internal orders before servicing outside orders. Each division has full responsibility over setting prices and sales targets as well as monitoring costs. Also, divisional managers have decision-making authority over fixed investments (capital equipment) up to $0.5 million as long as the investments can be internally financed. For any investment exceeding $0.5 million, final approval must be given by the SBU and head office.

For performance evaluation purposes, Riverside uses two basic measures to evaluate managers. First, it uses budgeted income, and second, return on investment (ROI). Divisional managers develop their budgets in line with goals set centrally for the organization. All budgets must be approved by the SBU and central executive before final acceptance. Net income includes headquarters' allocations based on a percentage of divisional sales. ROI is calculated as net income divided by total assets. As with the budget target, the ROI target has to be approved. Although the weighted average cost of capital for the company is 12%, each division negotiates its target ROI according to past performance and perceived risks and uncertainty in the environment. Progress toward the budgeted income and ROI targets are evaluated on a quarterly basis.

Riverside's bonus compensation scheme was extended to its divisional managers last year. The bonus consists of a "50/50 cash plus deferred payment" scheme that is measured each quarter. For example, if a division manager exceeds budgeted income and ROI targets for the division, then the manager is awarded a bonus, 50% of which is paid immediately in cash and 50% of which is invested in "phantom shares" that can be redeemed three years hence, given continued good performance. The total value of the bonuses range from 10 to 100% of regular salary, depending on how well managers did and their level in the organization. Actual amounts of bonuses earned in any given year depend on the centrally calculated bonus pool, which is defined as a percentage of overall company income.

Some of the divisional managers have been unhappy with the bonus compensation scheme. They felt they were at a disadvantage because of their lack of control over their prices (due to the nature of the external market), and their inability to achieve the growth in the ROI required by central headquarters. The division managers believed that a shift to residual income would help, but Riverside's CEO rejected this, feeling that residual income would not allow comparison of divisional results. The results of three of these divisions are shown below.

As well, the managers of the Primary Operating Divisions wanted the restrictions on the internal versus external sales lifted so that they could achieve better results than they were currently experiencing.

                                                  Division A               Division B                  Division C

Budgeted net income             $ 185                  $1,964                       $ 895

Actual net income                  $148                    $1,968                      $1,020

Budgeted total assets               $1,310                   $8,755                    $6,978

Actual total assets                    $1,109                   $8,811                   $6,955

Target ROI                                  14.12%                22.4%                       12.8%

Actual ROI                                   13.3%                   22.3%                   14.7%

REQUIRED

Question 1. a. Calculate the residual income figure for each of the three divisions.

Question b. In point form, list the advantages and disadvantages that residual income might have over the use of ROI at Riverside.

Question 2. Evaluate the management control system currently in place at Riverside, outlining its strengths and weaknesses, and make recommendations for any changes you feel are necessary