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

Exercise 35

Economic Value Added

Refer to the facts in Problem 14-33. Assume that Pitt’s performance measurement and bonus plans are based on residual income instead of ROI. Pitt uses a cost of capital of 12 percent in computing residual income.

Required

a. What is Forbes Division’s residual income if Oscar does not acquire the new machine?

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b. What is Forbes Division’s residual income this year if Oscar acquires the new machine?

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c. If Oscar acquires the new machine and operates it according to specifications, what residual income is expected for next year?

Step 1 of 5

Residual income is the excess income over required rate of return. It is useful measure for banks to know company’s financial position and it shows the company’s ability to repayment of their loans.

Residual income is calculated using following formula.

Residual Income = operating income ? (Minimum rate of return ×operating assets)