Question

ROI, Residual Income

Raddington Industries produces tool and die machinery for manufacturers. The company expanded vertically in 20x1 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 24 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 35 percent attributed to sales volume. Keimer contemplated a capital acquisition with an estimated ROI of 25.60 percent; however, division management decided against the investment because it believed that the investment would decrease Keimer's overall ROI.

The 20x2 operating statement for Keimer follows. The division's operating assets employed were $12,358,500 at November 30, 20x2, a 5 percent increase over the 20x1 year-end balance.

Keimer Steel Company Operating Statement For the Year Ended November 30, 20x2
Sales revenue				$25,433,000
Less expenses:
Cost of goods sold		$15,768,460
Administrative expenses		3,768,100
Selling expenses		2,757,000		22,293,560
Operating income before income taxes				$3,139,440

Required:

1. Calculate the unit contribution for Keimer Steel Company if 1,195,600 units were produced and sold during the year ended November 30, 20x2. Round your answer to the nearest cent.
$  per unit

2. Calculate the following performance measures for 20x2 for Keimer Steel Company:

a. Pretax return on average investment in operating assets employed (ROI). Round your percentage answer to two decimal places (for example, the decimal .10555 would be entered as "10.56" percent).
%

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.

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)

Answer 1

Answer with working is given below

Calculation of Unit Contribution Total $25,433,000 Per Unit $21.27 Sales Revenue Less: Variable Cost Cost of Goods sold Selling expense Contribution $15,768,460 $964,950 $8,699,590 $13.19 $0.81 $7.28 $12,358,500 $11,770,000 Average Operating Assets employed Closing Operating Assets employed Opening Operating Assts employed (Closing Operating Assets/1.05) Average Operating Assets employed (Opening + Closing)/2 $12,064,250 2 a) Return on Average Investment in Operating Assts Operating Income $3,139,440 Average Operating Assets $12,064,250 26.0% 2b) Residual Income Operating Income Less: Opportunity cost of capital ($12,064,250* 24%) Residual Income $3,139,440 $2,895,420 $244,020 3 Residual income measure of division performance is considered superior compared to ROI measure. Because in Residual income measure opportunity cost of capital is charged against income and if Residual income is positive it is accepted. ROI only gives return on the total investment and hence may not be appropriate to use in few situations Since Keimer Steel company is a separate investment centre. All Revenues, Cost and Operating Assets should be separately tracked for this division A Division performance can be measured only when all revenues, cost and investments relating to it are separately maintained Common expenses should not be allocated to the department