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ROI and residual income

Problem 10-13A Return on Investment (ROI) and Residual Income; Decentralization (LO1,LO2)
Kramer Industries produces tool and die machinery for manufacturers. Several years ago the company acquired Douglas Steel Company, one of its suppliers of alloy steel plates. Kramer Industries decided to maintain Douglas's separate identity and therefore established the Douglas Steel Division as one of its investment centers.

Kramer Industries evaluates its divisions on the basis of ROI. Management bonuses are also based on ROI. All investments in operating assets are expected to earn a minimum required rate of return of 16%.

Douglas's ROI has ranged from 19% to 22% since it was acquired by Kramer Industries. During the past year, Douglas had an investment opportunity that would yield an estimated return of 18%. Douglas's management decided against the investment because it believed the investment would decrease the division's overall ROI.

Last year's absorption costing income statement for Douglas Steel Division is given below. The division's operating assets were $16,800,000 at the end of the year, which represents an increase of 5% over the previous year-end balance.
Douglas Steel Division
Divisional Income Statement
For the Year Ended December 31
Sales $41,000,000
Cost of Goods Sold 20,863,000
Gross Margin 20,137,000
Selling and Administrative expenses:
Selling expenses $7,385,000
Administrative expenses 9,472,000 16,857,000
Net Operating Income $3,280,000

1. Compute the following performance measures for the Douglas Steel Division:
a. ROI. (Remember, ROI is based on the average operating assets, computed from the beginning-of-year and end-of-year balances.) State ROI in terms of margin and turnover.
b. Residual income.
2. Would the management of Douglas Steel Division have been more likely to accept the investment opportunity it had last year if residual income were used as a performance measure instead of ROI? Explain.
3. The Douglas Steel Division is a separate investment center within Kramer Industries. Identify the items Douglas must be free to control if it is to be evaluated fairly by either the ROI or residual income performance measures.

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Solution Summary

The solution explains the performance evaluation using ROI and residual income