Responsibility Accounting and Performance Measures Paper 6
To properly motivate divisional management, the divisional ROIs should be
Answer (D) is correct. Each division within a firm should have an ROI based on the strategic goals of the firm consistent with its competitive environment.
Which one of the following items would most likely not be incorporated into the calculation of a divisionís investment base when using the residual income approach for performance measurement and evaluation.
Answer (B) is correct. An evaluation of an investment center is based upon the return on the investment base. These assets include plant and equipment, inventories, and receivables. Most likely, however, an asset, such as land, that is being held by the division as a site for a new plant would not be included in the investment base because it is not currently being used in operations. Total assets in use rather than total assets available is preferable when the investment center has been forced to carry idle assets.
The segment margin of an investment center after deducting the imputed interest on the assets used by the investment center is known as
Answer (B) is correct. Residual income is the excess of the amount of return on investment (ROI) over a targeted amount equal to an imputed interest charge on invested capital. The rate used to impute the interest is usually the weighted-average cost of capital. The advantage of using residual instead of a percentage. Managers are encouraged to accept projects with returns exceeding the cost of capital even if the investments reduce the percentage ROI.
The imputed interest rate used in the residual income approach for performance measurement and evaluation can best be characterized as the
Answer (D) is correct. Normally, management sets a target rate that all managers are expected to achieve. Anything above or below this normal return will catch the attention of higher management.
James Webb is the general manager of the Industrial Product Division, and his performance is measured using the residual income method. Webb is reviewing the following forecasted information for his division for next year: Category ............Amount (thousands) Working capital .....$ 1,800 Revenue .................30,000 Plant and equipment 17,200 If the imputed interest charge is 15% and Webb wants to achieve a residual income target of $2,000,000, what will costs have to be in order to achieve the target?
Answer (C) 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 Ė $4,850,000 profit).
The basic objective of the residual income approach to performance measurement and evaluation is to have a division maximize its
Answer (D) is correct. Residual income is the excess of the return on an investment over the targeted amount. This amount may be defined as the imputed interest on invested capital. Some firms prefer to measure managerial performance in terms of the amount of residual income rather than the percentage ROI. The principle is that the firm 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.
After investing in a new project, a company discovered that its residual income remained unchanged. Which one of the following must be true about the new project?
Answer (C) is correct. Residual income is the excess of the return on an investment over the firmís cost of capital. If residual income remained unchanged, then the return on the project must have been the same as the firmís cost of capital.
When comparing the residual income of several investment centers, the validity of comparisons may be destroyed by
Answer (A) is correct. Residual income is income of an investment center, minus an imputed interest charge for invested capital. The theory is that earning an income greater than residual income indicates that expansion is desirable. However, comparisons of investment centers based on residual income may be misleading because of differences in products, markets, costs, and local conditions.
The following information relates to Cinder Co.ís Northeast Division:
Variable costs 360,000
Traceable fixed costs 60,000
Average invested capital 120,000
Imputed interest rate 8%
Cinderís residual income was
Answer (A) is correct.
Residual income is income of an investment center minus an imputed interest charge for
invested capital. Accordingly, Cinderís residual income is $170,400 [($600,000 sales Ė
$360,000 variable costs Ė $60,000 traceable fixed costs) net income Ė ($120,000 average
invested capital ◊ 8%) imputed interest].
KHD Industries is a multidivisional firm that 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 divisionís ROI exceeds 15%.
David Evans, manager of the Consumer Products Division, has made a forecast of the
divisionís 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
Assuming no restrictions on expenditures, what is the optimal mix of new programs that
would add value to KHD Industries?
Answer (B) is correct.
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 KHDís case, a firm should invest in any project
whose return is expected to exceed the cost of capital.