Cost Management: A Strategic Emphasis 5th Edition by David Stout, Edward Blocher, Gary Cokins

Exercise 59

Return on Investment (ROI); Residual Income (RI) Jump-Start Co. (JSC), a subsidiary of Mason Industries, manufactures go-carts and other recreational vehicles. Family recreational centers that feature go-cart tracks as well as miniature golf courses, batting cages, and arcade games have increased in popularity. As a result, Mason management has been pressuring JSC to diversify into some of these other recreational areas. Recreational Leasing Inc. (RLI), one of the largest firms that leases arcade games to these family recreational centers, is looking for a buyer. Mason’s top management believes that RLI’s assets could be acquired for an investment of $3.2 million and has strongly urged Bill Grieco, JSC’s division manager, to consider the acquisition.

Bill has reviewed RLI’s financial statements with his controller, Marie Donnelly; they believe that the acquisition may not be in JSC’s best interest. “If we decide not to do this, the Mason people are not going to be happy,” Bill said. “If we could convince them to base our bonuses on something other than ROI, maybe this acquisition would look more attractive. How would we do if the bonuses were based on RI using the company’s 15 percent cost of capital?”

Mason has traditionally evaluated all divisions on the basis of ROI, which is the ratio of operating income to total assets. The desired rate of return for each division is 20 percent. The management team of any division reporting an annual increase in ROI is automatically eligible for a bonus. To be eligible for a bonus, the management of divisions reporting a decline in ROI must provide convincing explanations for the decline. The bonus for divisions with a declining ROI is limited to 50 percent of the amount of the bonus paid to divisions reporting an increase.

The following are the condensed financial statements of JSC and RLI for the fiscal year ended May 31, 2010.

	JSC	RLI
Sales revenue	$10,500,000	—
Leasing revenue	—	$2,800,000
Variable expenses	7,000,000	1,000,000
Fixed expenses	1,500,000	1,200,000
Operating income	$ 2,000,000	$ 600,000
Current assets	$ 2,300,000	$1,900,000
Long-term assets	5,700,000	1,100,000
Total assets	$ 8,000,000	$3,000,000
Current liabilities	$ 1,400,000	$ 850,000
Long-term liabilities	3,800,000	1,200,000
Shareholders’ equity	2,800,000	950,000
Total liabilities and shareholders’ equity	$ 8,000,000	$3,000,000

Required

1. If Mason Industries continues to use ROI as the sole measure of divisional performance, explain why JSC would be reluctant to acquire RLI. Support your answer with appropriate calculations.

---

2. If Mason Industries could be persuaded to use RI to measure JSC’s performance, explain why JSC would be more willing to acquire RLI. Support your answer with appropriate calculations.

---

3. Discuss how the behavior of division managers is likely to be affected by the use of:

a. ROI as a performance measure.

b. RI as a performance measure.

Step 1 of 3

1.?If Mason Industries continues to use return on investment as the sole measure of division performance, JSC would be reluctant to acquire Recreational Leasing Inc. because the post-acquisition combined return on investment would decrease, as shown below.

?	Return on Investment (ROI)
?	JSC	RLI	Combined	?
Operating Income	$2,000,000	$600,000	$2,600,000	?
Total Assets	8,000,000	$3,000,000	11,000,000	?
ROI	25%	20%	23.64%	?

This would result in JSC's management either losing their bonuses, or having their bonuses limited to 50% of the eligible amounts, if management could provide convincing explanations for the decline in return on investment.