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

Exercise 24

Impact of New Asset on Performance Measures

Ocean Division currently earns $780,000 and has divisional assets of $3.9 million. The division manager is considering the acquisition of a new asset that will add to profit. The investment has a cost of $675,000 and will have a yearly cash flow of $168,000. The asset will be depreciated using the straight-line method over a six-year life and is expected to have no salvage value. Divisional performance is measured using ROI with beginning-of-year net book values in the denominator. The company’s cost of capital is 15 percent. Ignore taxes.

Required

a. What is the divisional ROI before acquisition of the new asset?

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b. What is the divisional ROI in the first year after acquisition of the new asset?

Step 1 of 6

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.