19-42 Calculating Return on Investment (ROI) and Residual Income (RI); Comparing

Question

19-42 Calculating Return on Investment (ROI) and Residual Income (RI); Comparing Results Blackwood Industries manufactures die machinery. To meet its expansion needs, it recently (2014) acquired one of its suppliers, Delta Steel. To maintain Delta’s separate identity, Blackwood reports Delta’s operations as an investment center. Blackwood monitors all of its investment centers on the basis of return on investment (ROI). Management bonuses are based on ROI, and all investment centers are expected to earn a minimum 10% return before income taxes. Delta’s ROI has ranged from 14% to 18% since 2014. The company recently had the opportunity for a new investment that would have yielded a 13% ROI. However, division management decided against the investment because it believed that the investment would decrease the division’s overall ROI. The 2016 operating statement for Delta follows. The division’s operating assets were $16,000,000 at the end of 2016, a 6% increase over the 2015 year-end balance.

DELTA DIVISION

Operating Statement for Year Ended

December 31, 2016 (000s omitted)

Sales                                                                           $29,500

Cost of goods sold 19,920

Gross profit 9,580

Operating expenses:

Administration          $2,808

Selling                         4,332 7,140

Operating income $2,440

Required

1. Calculate the following performance measures for 2016 for the Delta division:

a. Return on average investment in operating assets.

b. Residual income (RI) calculated on the basis of average operating assets.

2. Which performance measure (ROI or RI) should Blackwood Industries use to provide the proper incentive for each division to act autonomously in the firm’s best interests? Would Delta’s management have been more likely to accept the capital investment opportunity if RI had been used as a performance measure instead of ROI? Explain.

3. What type of strategic performance measurement do you recommend for the Delta division? Explain.

Explanation / Answer

Solution 1:

Operating assets - 2016 = $16,000,000

Operating assets - 2015 = $16,000,000 / 106% = $15,094,340

Average operating assets for 2016 = ($15,094,340 + $16,000,000) /2 = $15,547,170

Return on average investment = Operating income / Average operating assets

= $2,440,000 / $15,547,170 = 15.69%

Residual income = Operarting income - Minimum required return

= $2,440,000 - ($15,547,170 * 10%) = $885,283

Solution 2:

Blackwood industries should use Residual income performance measure to provide the proper incentive for each division to act autonomously in the firm’s best interests.

Yes, Delta’s management have been more likely to accept the capital investment opportunity if RI had been used as a performance measure instead of ROI. The reason is that if ROI is performance measure, then current ROI of Delta is higher than ROI offered by new investment opportunity, if Delta accept the new investment opportunity, its overall ROI will decrease. On the other hand, if RI is used as a performance measure, then ROI offered by new investment opportunity is higher than minimum required return of the company, therefore accepting investment oppornity will increase residual income of delta division.

Solution 3:

I will recommend Residula income performance measurement apprach for Delta division, so that all investment opportunity providing return greater than minimum required return should be accepted by delta division.

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