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

Exercise 22

ROI versus RI

A division is considering the acquisition of a new asset that will cost $720,000 and have a cash flow of $252,000 per year for each of the four years of its life. Depreciation is computed on a straight-line basis with no salvage value. Ignore taxes.

Required

a. What is the ROI for each year of the asset’s life if the division uses beginning-of-year asset balances and net book value for the computation?

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b. What is the residual income each year if the cost of capital is 15 percent?

Step 1 of 9

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.