Problem 10.26 ROI, Residual Income Raddington Industries produces tool and die m

Question

Problem 10.26
ROI, Residual Income

Raddington Industries produces tool and die machinery for manufacturers. The company expanded vertically in 2014 by acquiring one of its suppliers of alloy steel plates, Keimer Steel Company. To manage the two separate businesses, the operations of Keimer are reported separately as an investment center.

Raddington monitors its divisions on the basis of both unit contribution and return on average investment (ROI), with investment defined as average operating assets employed. Management bonuses are determined on ROI. All investments in operating assets are expected to earn a minimum return of 13 percent before income taxes.

Keimer's cost of goods sold is considered to be entirely variable, while the division's administrative expenses are not dependent on volume. Selling expenses are a mixed cost with 40 percent attributed to sales volume. Keimer contemplated a capital acquisition with an estimated ROI of 14.5 percent; however, division management decided against the investment because it believed that the investment would decrease Keimer's overall ROI.

The 2015 operating statement for Keimer follows. The division's operating assets employed were $12,600,000 at November 30, 2015, a 5 percent increase over the 2014 year-end balance.

Required:

1. Calculate the unit contribution for Keimer Steel Company if 1,187,000 units were produced and sold during the year ended November 30, 2015. Round your answer to the nearest cent.
$   per unit

2. Calculate the following performance measures for 2015 for Keimer Steel Company:

a. Pretax return on average investment in operating assets employed (ROI).
  %

b. Residual income calculated on the basis of average operating assets employed.
$  

3. Explain why the management of Keimer Steel Company would have been more likely to accept the contemplated capital acquisition if residual income rather than ROI were used as a performance measure.
- Select your answer -Management is likely to reject any investment that would increase the overall ROI. The investment would have increased both the division's residual income and the management bonuses. The investment would have decreased the division's residual income but increased its ROI. Item 4

4. Keimer Steel Company is a separate investment center within Raddington Industries. Identify several items that Keimer should control if it is to be evaluated fairly by either the ROI or residual income performance measures. (CMA adapted)
- Select your answer -Keimer must be able to control all items related to investment but not to profits.Keimer must be able to control items related to profits but not to investment.Keimer must be able to control all items related to profits and investment.Item 5

Explanation / Answer

1)Total variable expense= [2700000*0.40]+$16500000= $17,580,000 Contribution = $25,000,000-$17,580,000= $7,420,000 Per unit contribution margin = $74,20,000/ 1187000 =$ 6.25 per unit 2.a)Investmen in 2014 = $12,600,000/1.05= 12,000,000 Average investment= [$12,000,000+$12,600,000]/2= $12,300,000 ROI = $18,45,000/$12,300,000 =0.15 or 15% 2.b)Residual income =Pretax income * [ROI * Avergae capital invested]                  = $18,45,000- [ $12,300,000*0.13]                   = $18,45,000- $15,99,000= $2,46,000 3)The management of Keimer Steel would have been more likely to accept the contemplated capital acquisition if residual income (RI) were employed as the performance measure for the reason that the investment will raise the division’s residual income and the management bonuses as well. Using RI, management would be ready to accept all investments with a return higher than 12% as these investments would all increase the value of Residual Income. 4)Several factor to control- - It can encourage managers to focus on short-term performance, at the cost of the long term which can result in reduced performance in the future. - In the same way, excessive cost-cutting activities can improve short-term ROI, but can harm the business’s competitiveness in future -Like ROI, residual income can also encourage a short-term focus rather than long term

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