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ROI and residual income

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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

Required
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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The solution explains the performance evaluation using ROI and residual income

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Suburban Lifestyles, Inc. has manufactured prefabricated houses for over 20 years. The houses are constructed in sections to be assembled on customers' lots. Suburban Lifestyles expanded into the precut housing market when it acquired Fairmont Company, one of its suppliers. In this market, various types of lumber are precut into the appropriate lengths, banded into packages, and shipped to customers' lots for assembly. Suburban Lifestyles' management designated the Fairmont Division as an investment center. Suburban uses return on investment (ROI) as a performance measure with invest part on ROI. All investments are expected to earn a minimum return of 15 percent before income taxes. Fairmont's ROI has ranged from 19.3 to 22.1 percent since it was acquired. Fairmont had an investment opportunity in 20x1 that had an estimated ROI of 18 percent. Fairmont's management decided against the investment because it believed the investment would decrease the division's overall ROI. The 20x1 income statement for Fairmont Division follows. The division's productive assets were $25,200,000 at the end of 20x1, a 5 percent increase over the balance at the beginning of the year.

FAIRMONT DIVISION
Income Statement
For the Year Ended December 31, 20x1
(in thousands)
Sales revenue ................................................................................................................................................. $48,000
Cost of goods sold ........................................................................................................................................... 31,600
Gross margin .............................................................................................................................................. $16,400
Operating expenses:
Administrative ............................................................................................................................ $4,280
Selling ...................................................................................................................................... 7,200 11,480
Income from operations before income taxes ..................................................................................................... $ 4,920

1. Calculate the following performance measures for 20x1 for the Fairmont Division.
a. Return on investment (ROI).
b. Residual income.

2. Would the management of Fairmont Division have been more likely to accept the investment
opportunity it had in 20x1 if residual income were used as a performance measure instead of ROI?
Explain your answer.

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