Responsibility Accounting and Performance Measures Paper 7
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?
Answer (A) is correct. 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)].
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
Answer (A) is correct. 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.
Ramirez, Inc., opens a new retail store every 2 years and currently operates in 24 different locations. Ramirez uses return on investment (ROI) to evaluate store performance. The best comparison among stores will be achieved if Ramirez values long-term assets by
Answer (B) is correct. Since Ramirez opens stores every 2 years, and not all in the same year, the best method of comparing the stores is to value long-term assets at current values. This will make the ROIs comparable between the stores at any given moment in time.
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
Answer (D) is correct. 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).
A company uses return on investment (ROI) to evaluate year-end divisional performance. Which one of the following inventory practices would most reduce comparability among two similar divisions?
Answer (C) is correct. If two divisions use different inventory flow assumptions, comparability of ROI is significantly reduced, since these two methods will affect both net income (through cost of goods sold) and the value of assets on the balance sheet. Although it is possible to recalculate amounts to increase comparability, this could be difficult and time-consuming.
A company uses return on investment (ROI) to measure the performance of its business
units. The company manufactures and distributes consumer goods. Last year, management
identified a possible shortage of raw materials. To mitigate this risk, a large amount of raw
material was bought in advance and stored in the manufacturing plant inventory. As a result
of this decision, ROI will
Answer (B) is correct.
Return on investment (ROI) is calculated by dividing business unit
profits over average total assets. The raw materials bought in advance
and stored in the manufacturing plant inventory will increase the
denominator of the fraction. The numerator remains unchanged since the
facts do not indicate any excess profit after the materials were bought in
advance. If the numerator is unchanged and the denominator increases,
the total fraction will decrease.
Teen Style, a merchandising company, is considering a $1,000,000 upgrade to its retail and
warehousing facilities that will allow the company to handle more products and attract more
customers. Teen Style anticipates that sales will increase by $500,000 and operating
income will increase by $200,000 per year. If Teen Style has a minimum required return on
investment of 15%, what would be the residual income resulting from the upgrade?
Answer (D) is correct.
Residual income measures performance in dollar terms rather than as a
percentage return. It is calculated using the following formula: Business
unit profit – (Assets of business unit × Required rate of return). Thus,
Teen Style’s residual income resulting from the upgrade will equal
$50,000 [$200,000 – ($1,000,000 × 15%)]. The $500,000 sales figure is a
distractor and should not be used in the calculation.
A corporation has set a goal to increase its return on investment (ROI). To facilitate this
goal, the corporation has set up an incentive program that rewards each division for
increasing its ROI. One possible downfall of this incentive program is that it will
Answer (D) is correct.
A major problem with using ROI is that an investment center with a high ROI may not accept a profitable investment even though the investment’s return is higher than the center’s target ROI. An investment center has a 7% ROI, and its investors expect 3% (the target return). The decision maker may reject a project earning 5% even though the project exceeds the target.
Which statement below best represents a benefit of residual income (RI) as a performance measure?
Answer (D) is correct. Residual income measures performance in dollar terms and is calculated as follows: Business unit profit – (Assets of business unit × Required rate of return). By using the residual income method, managers maximize an absolute amount and invest as long as the required return is earned because managers make their decisions on whether the residual income is positive or negative. If it is positive, it means that the required return is being earned.
REB Service Co. is a computer service center. For the month, REB had the following operating statistics: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? REB has a
Answer (B) is correct. Return on investment is commonly calculated by dividing pretax income by total assets available. Residual income is the excess of the return on investment over a targeted amount equal to an imputed interest charge on invested capital. The rate used is ordinarily the weighted-average cost of capital. Some companies measure managerial performance in terms of the amount of residual income rather than the percentage return on investment. Because REB has assets of $500,000 and a cost of capital of 6%, it must earn $30,000 on those assets to cover the cost of capital. Given that operating income was only $25,000, it had a negative residual income of $5,000.