Wyalusing Industries has manufactured prefabricated houses for over 20 years. Th
ID: 2572205 • Letter: W
Question
Wyalusing Industries has manufactured prefabricated houses for over 20 years. The houses are constructed in sections to be assembled on customers lots. Wyalusing expanded into the precut housing market when it acquired Fairmont Company, one of it's suppliers. In this market, various types of lumber are precut into appropriate lengths, banded into packages, and shipped to customers for lots of assembly. Wyalusing designated the Fairmont division as an investment center. Wyalusing uses return on investment (ROI) as a performance measure with investment defined as average productive assets. Management bonuses are based in part on ROI. All investments are expected to earn a minimum return of 15 percent before income taxes. Fairmont's ROI has ranged from 19.3 to 22.1 percent since it was acquired. Fairmont had an investment opportunity in 20x1 that had an estimated ROI of 18 percent. Fairmont's management decided against the investment because it believed the investment would decrease the division's overall ROI. The 20X1 income statement for Fairmont Divison follows. The division's productive assets were $13,520,000 at the end of 20X1, a 4% increase over the balance at the beginning of the year. Fairmont Division Income Statement For the Year Ended December 31, 20x1 (in thousands) Sales revenue 22,500 Cost of goods sold 13,900 Gross margin 8,600 Operating Expenses: Administrative 1,800 Selling 4,300 6,100 Income from operations before income taxes 2,500 Required: 1. Calculate the following perofrmance measures for 20x1 for the Fairmont Division. a. Return on Investment (ROI) b. Residual Income 2. Would the management of Fairmont Division have been more likely to accept the investment opportunity it had in 20X1 if residual income were used as a performance measure instead of ROI? Explain your answer.
Explanation / Answer
1a. Return on Investment = Net income / Average investment = $2,500,000 / $13,260,000 = 18.85%
Average investment (operating assets) = (Beginning operating assets + Ending operating assets) / 2 = ($13,000,000 + $13,520,000) / 2 = $13,260,000
Beginning operating assets = $13,520,000 x 100 / 104 = $13,000,000
1b. Residual income = Net operating income – Desired net operating income = $2,500,000 - $1,989,000 = $511,000
Desired net operating income = 15% x Average operating assets = 15% x $13,260,000 = $1,989,000
2. A positive residual income of $511,000 denotes that the investment opportunity would generate more than the desired income and hence the investment opportunity should be accepted.
Thus, if residual income was used as the performance measure instead of the return on investment, it was more likely that Fairmont Division’s management would have accepted the investment opportunity.
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