Fundamentals of Cost Accounting 3rd Edition by William N. Lanen, Shannon W. Anderson, Michael Maher

Exercise 18

“Residual income solves some of the problems with ROI, but because it is an absolute number, it is difficult to compare divisions. We should use residual income divided by assets and then we would have the best of both measures.” Do you agree with this statement?

Step 1 of 2

Divisional performance management

Performance measures are developed to assess the divisional performance. Performance measures should be consistent with authority granted and performance measures should assess the effectiveness of actions. Company should also consider those actions of divisional managers that improve the divisional performance but are unfavorable to organization performance. Divisions are assessed on income earned because divisions have revenue and cost both.

Return on investment

Return on income is used as a measure to the divisional performance. This a ratio that indicates relationship between two variables i.e. income after tax and divisional assets. It may be calculated by multiplying two ratios i.e. profit margin ratio and asset turnover.

Return on investment is calculated by dividing the income after tax with the amount of divisional assets.

Residual income

This is another measure used to evaluate divisional performance. This is not a ratio. Residual income is calculated by deducting the cost of investment from the amount of income after tax. Cost of investment is calculated by multiplying the cost of capital with amount of divisional assets.