16.3 Performance Measures -- Investment Centers

Question 1

Formula for Return on Investment (ROI)

Answer 1

Business unit profit / Assets of business unit

Question 2

Formula for Residual Income

Answer 2

Business unit profit - (assets x required rate of return)

required rate of return = opportunity cost for the business unit investments

Question 3

Which statement below best represents a benefit of residual income (RI) as a performance measure?

A. RI blends all ingredients of profitability into one percentage that is easily comparable
B. RI is more likely to promote goal congruence in a low-profit location versus return on investment
C. Managers can increase their RI by decreasing the internal rate of return
D. Managers maximize an absolute amount and invest as long as the required return is earned

Answer 3

D. Managers maximize an absolute amount and invest as long as the required return is earned

Question 4

Business unit A has a return on investment of 10%, with a net profit for the year of $40,000. The opportunity cost for the business unit investments has been calculated at 8%. The company plans to purchase a new machine worth $100,000 and expects the net profit to rise by an additional $15,000. The new purchase decision will increase the return on investment

A. By 1% and increase the residual income by $8,000
B. By 1% and increase the residual income by $15,000
C. To 11% and increase the residual income by $7,000
D. to 11% and increase the residual income by $15,000

Answer 4

C. To 11% and increase the residual income by $7,000

ROI = (40,000 + 15,000) / ( ? + 100,000)

If the ROI is 10% before adding the new investment, the original assets are $400,000 (10% x $400,000 = $40,000)

ROI = (40,000 + 15,000) / (400,000 + 100,000)
ROI = 55,000 / 500,000 = 11%

Residual income = business unit profit - (assets x required rate of return)
= 15,000 - (100,000 x 8%)
= 15,000 - 8,000 = 7,000

Question 5

The imputed interest rate used in the residual income approach to performance evaluation can best be described as the

A. Average lending rate for the year being evaluated.
B. Historical weighted-average cost of capital for the company.
C. Target return on investment set by the company’s management.
D. Average return on investments for the company over the last several years.

Answer 5

C. Target return on investment set by the company’s management.

Residual income is the excess of operating income over a targeted amount equal to an imputed interest charge on invested capital. The rate used ordinarily is set as a target return by management but is often equal to the weighted average cost of capital. Some entities prefer to measure managerial performance in terms of the amount of residual income rather than the percentage ROI because the firm will benefit from expansion as long as residual income is earned.

Question 6

A computer service center had the following operating statistics for the month:

• Sales: $450,000
• Operating income: 25,000
• Net profit after taxes: 8,000
• Total assets: 500,000
• Shareholders’ equity: 200,000
• Cost of capital: 6%

Based on the above information, which one of the following statements is true? The computer service center has a

A. Return on investment of 4%.
B. Residual income of $(5,000).
C. Return on investment of 1.6%.
D. Residual income of $(22,000).

Answer 6

B. Residual income of $(5,000).

Residual income is the excess of operating income (a pretax amount) over a targeted amount equal to an imputed interest charge on invested capital. Using assets of $500,000 as the investment base and a cost of capital of 6%, the computer service center must earn $30,000 on those assets to cover the cost of capital. Given that operating income was only $25,000, residual income is $(5,000).

Question 7

A firm earning a profit can increase its return on investment (ROI) by

A. Increasing sales revenue and operating expenses by the same dollar amount.
B. Decreasing sales revenues and operating expenses by the same percentage.
C. Increasing investment and operating expenses by the same dollar amount.
D. Increasing sales revenues and operating expenses by the same percentage.

Answer 7

D. Increasing sales revenues and operating expenses by the same percentage.

ROI equals income divided by invested capital. If a company is already profitable, increasing sales and expenses by the same percentage will increase ROI. For example, if a company has sales of $100 and expenses of $80, its net income is $20. Given invested capital of $100, ROI is 20% ($20 ÷ $100). If sales and expenses both increase 10% to $110 and $88, respectively, net income increases to $22. ROI will then be 22% ($22 ÷ $100).

Question 8

Listed below is selected financial information for the Western Division of a corporation for last year.

• Average working capital: $625
• General and administrative expenses: 75
• Net sales: 4,000
• Average plant and equipment: 1,775
• Cost of goods sold: 3,525

If the corporation treats the Western Division as an investment center for performance measurement purposes, what is the before-tax return on investment (ROI) for last year?

A. 34.78%
B. 22.54%
C. 19.79%
D. 16.67%

Answer 8

D. 16.67%

An investment center’s ROI is its operating income divided by its average invested capital. The Western Division’s operating income is $400 ($4,000 sales – $3,525 cost of goods sold – $75 general expenses). Given average plant and equipment of $1,775 and average working capital of $625, the total average invested capital is $2,400. ROI is thus 16.67% ($400 ÷ $2,400).

Question 9

Which one of the following items would most likely not be incorporated into the calculation of a division’s investment base when using the residual income approach for performance measurement and evaluation?

A. Fixed assets employed in division operations.
B. Land being held by the division as a site for a new plant.
C. Division inventories when division management exercises control over the inventory levels.
D. Division accounts payable when division management exercises control over the amount of short-term credit used.

Answer 9

B. Land being held by the division as a site for a new plant.

An evaluation of an investment center is based upon the return on the investment base. These assets include plant and equipment, inventories, and receivables. However, land not in use will most likely not be included in the investment base. Total assets in use rather than total assets available is preferable when the investment center has been forced to carry idle assets.

Question 10

Residual income is a better measure for performance evaluation of an investment center manager than return on investment (ROI) because

A. The problems associated with measuring the asset base are eliminated.
B. Desirable investment decisions will not be neglected by high-return divisions.
C. Only the gross book value of assets needs to be calculated.
D. The arguments about the implicit cost of interest are eliminated.

Answer 10

B. Desirable investment decisions will not be neglected by high-return divisions.

Residual income is the excess of the amount of the ROI over a targeted amount equal to an imputed interest charge on invested capital. The advantage of using residual income rather than percentage ROI is that the former emphasizes maximizing a dollar amount instead of a percentage. Managers of divisions with a high ROI are encouraged to accept projects with returns exceeding the cost of capital even if those projects reduce the department’s ROI.

Question 11

A multidivisional firm evaluates its managers based on the return on investment (ROI) earned by their divisions. The evaluation and compensation plans use a targeted ROI of 15% (equal to the cost of capital), and managers receive a bonus of 5% of basic compensation for every one-percentage point that the division’s ROI exceeds 15%. The manager of the Consumer Products Division has made a forecast of the division’s operations and finances for next year that indicates the ROI would be 24%. In addition, new short-term programs were identified by the Consumer Products Division and evaluated by the finance staff as follows:

Program: Projected ROI
A: 13%
B: 19%
C: 22%
D: 31%

Assuming no restrictions on expenditures, what is the optimal mix of new programs that would add value to the firm?

A. B, C, and D only
B. C and D only
C. A,B,C and D
D. D only

Answer 11

A. B, C, and D only

Return on investment (ROI) is one of the two most commonly used performance measures for investment centers. If sufficient capital is available, as it is in the firm’s case, a firm should invest in any project whose return is expected to exceed the cost of capital.

Question 12

The headquarters of a national restaurant chain is trying to better understand the profitability of the Savannah location. Savannah’s total assets are $3,500,000, consisting of $1,000,000 land, $2,000,000 buildings and equipment, and $500,000 intangibles. The net profit is $475,000, and the required rate of return is 12%. Savannah’s return on investment (ROI) is

A. 13.6%
B. 23.7%
C. 15.8%
D. 19.0%

Answer 12

A. 13.6%

ROI is equal to business unit profit over average total assets. Savannah has a net profit of $475,000 and total assets of $3,500,000. Therefore, ROI is equal to 13.6%. (475,000 / 3,500,000)

Question 13

Which one of the following will not improve return on investment if other factors are constant?

A. None of the answers is correct.
B. Increasing selling prices.
C. Decreasing expenses or assets.
D. Increasing sales volume while holding fixed expenses constant.

Answer 13

A. None of the answers is correct.

ROI equals net income divided by investment. Increasing net income (e.g., by decreasing expenses or by increasing prices or sales volume) or decreasing the investment base improves ROI. Hence, any of the actions listed increases the return on investment. Management and the accounting profession are very concerned with classification of expenses and assets and other decisions involving the accounting for these items to achieve a proper calculation of return on investment.

Question 14

Edith Carolina, president of the Deed Corporation, requires a minimum return on investment of 8% for any project to be undertaken by her company. The company is decentralized, and leaves investment decisions up to the discretion of the division managers as long as the 8% return is expected to be realized. Michael Sanders, manager of the Cosmetics Division, has had a return on investment of 14% for his division for the past 3 years and expects the division to have the same return in the coming year. Sanders has the opportunity to invest in a new line of cosmetics that is expected to have a return on investment of 12%.

If the Deed Corporation evaluates managerial performance using residual income based on the corporate minimum required rate of return, what will be the preference for taking on the proposed cosmetics line by Edith Carolina and Michael Sanders?

Carolina: Accept/Reject
Sanders: Accept/Reject

Answer 14

Carolina: Accept
Sanders: Accept

Residual income is the excess of the return on an investment over a targeted amount, which is equal to an imputed interest charge on invested capital (in this case, 8%). The rate is usually the weighted-average cost of capital. Some enterprises prefer to measure managerial performance in terms of the amount of residual income rather than the percentage ROI. The principle is that the enterprise is expected to benefit from expansion as long as residual income is earned. Using a percentage ROI approach, expansion might be rejected if it lowered ROI, even though residual income would increase. Using residual income, both Carolina and Sanders would accept the new project because residual income will increase if a 12% return is earned when the target ROI is only 8%.

Question 15

Performance results for four geographic divisions of a manufacturing company are shown below.

Division A
Target Return on Investment: 18%
Actual Return on Investment: 18.1%
Return on Sales: 8%

Division B
Target Return on Investment: 16%
Actual Return on Investment: 20%
Return on Sales: 8%

Division C
Target Return on Investment: 14%
Actual Return on Investment: 15.8%
Return on Sales: 6%

Division D
Target Return on Investment: 12%
Actual Return on Investment: 11%
Return on Sales: 9%

The division with the best performance is

A. Division D.
B. Division A.
C. Division B.
D. Division C.

Answer 15

C. Division B.

Return on investment, that is, the amount of return generated for the parent firm per dollar of capital invested, is the simplest and generally the soundest measure of divisional performance.

Question 16

A company is concerned that its divisional managers are not making decisions that are in the best interests of the overall corporation. In order to prevent this, the company should use a performance evaluation system that focuses on

A. Residual income.
B. Flexible budget variances.
C. Operating income.
D. Controllable costs.

Answer 16

A. Residual income.

Residual income is the excess of the return on investment over a targeted amount equal to an imputed interest charge on invested capital. Of the choices presented, this one is the most likely to present the divisional managers with an incentive to focus on increasing profitability for the firm as a whole.

Question 17

The following is an excerpt from a corporation’s most recent financial statements.

Current assets: $ 120,000
Total operating assets: 1,750,000
Current liabilities: 85,000
Total liabilities: 985,000
Sales: 1,240,000
Operating income: 365,000

The corporation’s required rate of return is 12%. What is its residual income?

A. $113,800
B. $123,600
C. $126,800
D. $155,000

Answer 17

D. $155,000

Residual income is equal to [Business unit profit – (Assets of business unit × Required rate of return)]. Therefore, residual income is equal to $155,000 [$365,000 – ($1,750,000 × .12)].

Question 18

A company is considering the addition of a new product line. The new product line is expected to generate a return higher than the cost of capital but lower than the current overall return on investment (ROI). If the company decides to add the potential new product line, residual income will

A. Decrease.
B. Remain unchanged.
C. Become higher than the firm’s return on investment.
D. Increase.

Answer 18

D. Increase.

Residual income is equal to operating income, minus investment, multiplied by the cost of capital. As the return will be higher than the cost of capital, residual income will increase. This problem highlights the usefulness of residual income, as if the company simply evaluated projects on return on investment, this project would be passed up, even if it produces more income.

Question 19

Performance of the general manager of the Industrial Product Division is measured using the residual income method. The general manager is reviewing the following forecasted information for the division for next year:

Amount in thousands

Working capital: $ 1,800
Revenue: 30,000
Plant and equipment: 17,200

If the imputed interest charge is 15% and the general manager wants to achieve a residual income target of $2,000,000, what will costs (cost of goods sold and other operating expenses) have to be in order to achieve the target?

A. $9,000,000
B. $25,150,000
C. $25,690,000
D. $10,800,000

Answer 19

Answer (B) is correct.
Residual income is the excess of the amount of the ROI over a targeted amount equal to an imputed interest charge on invested capital. If a manager has $19,000,000 of invested capital ($17,200,000 of plant and equipment + $1,800,000 of working capital), a 15% imputed interest charge equals $2,850,000. Adding $2,000,000 of residual income to the imputed interest results in a target profit of $4,850,000. This profit can be achieved if costs are $25,150,000 ($30,000,000 revenue – $4,850,000 profit).

Question 20

The following information relates to the Northeast Division:

Sales: $600,000
Variable costs: 360,000
Traceable fixed costs: 60,000
Average invested capital: 120,000
Imputed interest rate: 8%

Residual income was
A. $180,000
B. $189,600
C. $170,400
D. $230,400

Answer 20

C. $170,400

Residual income is income of an investment center minus an imputed interest charge for invested capital. Accordingly, residual income is $170,400 [($600,000 sales – $360,000 variable costs – $60,000 traceable fixed costs) net income – ($120,000 average invested capital × 8%) imputed interest].

Question 21

The following selected information is from the financial statements for the last fiscal year.

Current assets: $ 500,000
Fixed assets: 250,000
Current liabilities: 100,000
Long-term debt: 300,000
Stockholders’ equity: 350,000
Operating profit: 1,000,000
Income taxes: 400,000
Net income: 600,000

The company has a cost of capital of 10%. Balance sheet amounts remained constant throughout the year. The company’s residual income for last year was

A. $925,000
B. $575,000
C. $525,000
D. $975,000

Answer 21

A. $925,000

Residual income can be calculated as follows:
Residual income = Operating profit – (Assets of business unit × Required rate of return) = $1,000,000 – ($750,000 × 10%)
= $1,000,000 – $75,000
= $925,000

Question 22

The management team of a company is evaluating the use of either return on investment or residual income as a measure of the performance of the company’s lines of business. In a presentation about the two measures, which of the following statements are correct?
I. Both measures include key elements such as revenues, costs, and level of investments, which are critical for top management decision making.
II. Both measures avoid all potential goal-congruency problems within the organization.
III. The only disadvantage of the measures is that they both have a long-term focus rather than a short-term focus.
IV. Both measures can be manipulated to suit the user’s purposes as the calculation is based on accounting numbers.

A. III and IV only.
B. I and IV only.
C. II and III only.
D. I and II only.

Answer 22

B. I and IV only.

Both return on investment (ROI) and residual income use revenues and costs to derive the net income and investigate the relationship between net income and the investment in assets to generate such income. However, accounting elements used in the calculation, such as revenues and expenses, may be subject to manipulation. Potential goal-congruency problems within the organization may arise if ROI is used. Decision makers may tend to avoid choosing projects with ROIs lower than the current ROI to avoid reducing future ROI. Also, both measures have a short-term focus rather than a long-term focus.

Question 23

Edith Carolina, president of the Deed Corporation, requires a minimum return on investment of 8% for any project to be undertaken by her company. The company is decentralized, and leaves investment decisions up to the discretion of the division managers as long as the 8% return is expected to be realized. Michael Sanders, manager of the Cosmetics Division, has had a return on investment of 14% for his division for the past 3 years and expects the division to have the same return in the coming year. Sanders has the opportunity to invest in a new line of cosmetics that is expected to have a return on investment of 12%.

If the Deed Corporation evaluates managerial performance using return on investment, what will be the preference for taking on the proposed cosmetics line by Edith Carolina and Michael Sanders?

• Carolina: Accept/Reject
• Sanders: Accept/Reject

Answer 23

• Carolina: Accept
• Sanders: Reject

A company with an 8% ROI threshold should obviously accept a project yielding 12% because the company’s overall ROI would increase. The manager being evaluated on the basis of ROI who is already earning 14% will be unwilling to accept a 12% return on a new project because the overall ROI for the division would decline slightly. This absence of goal congruence suggests a weakness in ROI-based performance evaluation.

Question 24

A company’s management is planning on making an investment of $800,000 to launch a new product. In the first year, the new product is expected to generate sales of $200,000 and a contribution margin of $175,000. Incremental fixed costs are $50,000. The company’s expected return on investment in the first year is closest to

A. 25%.
B. 6%.
C. 16%.
D. 22%.

Answer 24

C. 16%.

ROI is calculated by dividing business unit profit by invested capital. The new investment will make a profit of $125,000 ($175,000 contribution margin – $50,000 incremental fixed costs). Hence, ROI = $125,000 ÷ $800,000 = 16%.

Question 25

A company evaluates its managers using management by objectives (MBO). All of the following are considered appropriate goals for measuring a division manager’s efficiency for a budgeting period except

A. Budgeted operating income.
B. Earnings per share projections.
C. A reduction in the organizational structure (fewer employees doing a given amount of work).
D. A targeted share of the market.

Answer 25

B. Earnings per share projections.

Any measure involving the firm’s stock is inappropriate for measuring segment manager performance. The stock price reflects the performance of the company as a whole.

Question 26

A company uses return on investment (ROI) to compare its divisions, using this evaluation to determine division manager bonuses. Which method of asset measurement would provide the best method of comparison?

A. Book value
B. Depreciated cost
C. Historical cost
D. Current cost

Answer 26

D. Current cost

Current cost reflects the current expected economic benefit that may arise from the asset. An ROI based on the current cost of assets can best match the income generated and the income-generating ability of the asset.