Question

Q2. For many years, Lawton Industries has manufactured prefabricated houses where the houses are constructed in sections to be assembled on customers’ lots. The company expanded into the pre-cut housing market in 2006 when it acquired Presser Company, one of its suppliers. In this market, various types of lumber are pre-cut into the appropriate lengths, banded into packages, and shipped to customers’ lots for assembly. Lawton decided to maintain Presser’s separate identity and, thus, established the Presser Division as an investment center of Lawton.

Lawton uses return on average investment (ROI) as a performance measure the investment defined as operating assets employed. Management bonuses are based in part on ROI. All investments in operating assets are expected to earn a minimum return of 15% before income taxes. Presser’s ROI has ranged from 19.3% to 22.1% since it was acquired in 2006. The division had an investment opportunity in the year just ended that had an estimated ROI of 18% but Presser’s management decided against the investment because it believed the investment would decrease the division’s overall ROI.

Presser’s operating statement for the year just ended is presented below. The division’s operating assets employed were $12,600,000 at the end of the year, a 5% increase over the balance at the end of the previous year.

Presser Division Operating Statement For the Year Ended December 31 ($000 omitted)

Sales revenue		$24,000
Cost of goods sold		15,800
Gross profit		$ 8,200
Operating expenses
Administrative	$2,140
Selling	3,600	5,740
Income from operations
before income taxes		$ 2,460

REQUIRED:

1.Calculate the following performance measures for the year just ended for the Presser Division of

Lawton Industries.

a. Return on average investment in operating assets employed (ROI).

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

2.    Would the management of Presser Division have been more likely to accept the investment opportunity it had during the year if residual income were used as a performance measure instead of ROI? Explain you answer.

3.    The Presser Division is a separate investment center with Lawton Industries. Identify and describe the items Presser must control if it is to be evaluated fairly by either the ROI or residual income performance measures.

Answer 1

Answer-1:

Answer-1(a): Balance end of current year Balance end of previous year Total 12,600,000 12,000,000 (12,600,000 / 1.05) 24,600,000 Average operating assets employed 12,300,000 (24,600,000/2) ROI = Income from operation / Avg. operating assets employed = 24,600,000 / 12,300,000 = 0.20 or 20% Answer-1(b): Income from operations Minimum return on assets employed Residual income 2,460,000 1,845,000 (12,300,000 < 0.15) 615,000

Answer-2:

Yes, Presser’s management probably would have accepted the investment if residual income were used. The investment opportunity would have lowered Presser’s ROI because the expected return (18%) was lower than the division’s historical returns as well as its actual ROI (20%) for the year just ended. Management rejected the investment because bonuses are based in part on the performance measure of ROI. If residual income were used as a performance measure (and as a basis for bonuses), management would accept any and all investments that would increase residual including the investment opportunity rejected in the year just ended.

Answer-3:

Presser must control all items related to profit (revenues and expenses) and investment if it is to be evaluated fairly as an investment center by either the ROI or residual income performance measures. Presser must control all elements of the business except the cost of invested capital, that being controlled by Lawton Industries.