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ROI and RI (residual income)

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Fred Halloway, East Division Manager: "I know headquarters wants us to add on that new product line, but I want to see the numbers before I make a move. Our division has led the company for three years, and I don't want any letdown now."
Kirsi Products is a decentralized company with four autonomous divisions. The divisions are evaluated on a basis of the return that they are able to generate on invested assets, with year-end bonuses given to the divisional managers who have the highest ROI figures. Operating results for the company's East Division for last year are given below.

Sales $ 20,000,000
Less variable expenses 13,000,000
Contribution margin 7,000,000
Less fixed expenses 5,500,000
Net operating income $ 1,500,000
Divisional operating assets $ 5,000,000

The company had an overall ROI of 15% last year (considering all divisions) and views a return of 12% on invested assets as being the minimum that any division should earn. The East Division has an opportunity to add a new product line that would require an investment of $3,000,000. The cost and revenue characteristics of the new product line per year would be:

Sales $9,000,000
Variable expenses 65% of sales
Fixed expenses $2,520,000

Required
1. a. Calculate the East Division's ROI for last year. ___________________

b. Recalculate the ROI supposing assuming that the new product line had been
added. ________________

2. Suppose that the performance is evaluated by the residual income (RI) approach.

a. Calculate the East Division's RI for last year. ___________________

b. Recalculate the RI supposing assuming that the new product line had been
added. ________________

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Solution Summary

The solution explains how to calculate the ROI and RI

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Residual Income (RI) be used to overcome ROI drawbacks

ROI is a useful performance measure for divisions' profitability As it is based on comparing profit with the investment value it is possible to be affected by depreciation. When we deduct the depreciation charges, the investment value goes down thus the ROI will increase even if profits remain the same.

What other drawbacks we can identify in the use of ROI as a performance measure of divisions?
How Residual Income (RI) can be used to overcome some of ROI's drawbacks?

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