University:
California State University, Northridge
Course:
ACCT 230 | Introduction to Managerial Accounting
Academic year:

2024
Views:

320

Pages:

22
Author:

foummafiodifeugh

Chapter 10 Decentralization Part 3 Learning Objective LO2 To compute residual income and understand the strengths and weaknesses of this method of measuring performance. 10-32 Residual Income – Another Measure of Performance Net operating income above some minimum return on operating assets 10-33 Calculating Residual Income Residual = income Net operating income ( Average operating assets × ) Minimum required rate of return This computation differs from ROI. ROI measures net operating income earned relative to the investment in average operating assets. Residual income measures net operating income earned less the minimum required return on average operating assets. 10-34 Residual Income – An Example  The Retail Division of Zepher, Inc. has average operating assets of $100,000 and is required to earn a return of 20% on these assets.  In the current period the division earns $30,000. Let’s calculate residual income. 10-35 Residual Income – An Example Operating assets $ 100,000 Required rate of return × 20% Minimum required return $ 20,000 Actual income Minimum required return Residual income $ 30,000 (20,000) $ 10,000 10-36 Motivation and Residual Income Residual income encourages managers to make profitable investments that would be rejected by managers using ROI. 10-37 Quick Check  Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s ROI? a. 25% b. 5% c. 15% d. 20% 10-38 Quick Check  Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s ROI? a. 25% ROI = NOI/Average operating assets b. 5% c. 15% = $60,000/$300,000 = 20% d. 20% 10-39 Quick Check  Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. If the manager of the division is evaluated based on ROI, will she want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year? a. Yes b. No 10-40 Quick Check  Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. If the manager of the division is evaluated based on ROI, will she want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year? ROI = $78,000/$400,000 = 19.5% a. Yes b. No This lowers the division’s ROI from 20.0% down to 19.5%. 10-41 Quick Check  The company’s required rate of return is 15%. Would the company want the manager of the Redmond Awnings division to make an investment of $100,000 that would generate additional net operating income of $18,000 per year? a. Yes b. No 10-42 Quick Check  The company’s required rate of return is 15%. Would the company want the manager of the Redmond Awnings division to make an investment of $100,000 that would generate additional net operating income of $18,000 per year? a. Yes ROI = $18,000/$100,000 = 18% b. No The return on the investment exceeds the minimum required rate of return. 10-43 Quick Check  Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s residual income? a. $240,000 b. $ 45,000 c. $ 15,000 d. $ 51,000 10-44 Quick Check  Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s residual income? a. $240,000 b. $ 45,000 operating income $60,000 c. $ 15,000 Net Required return (15% of $300,000) $45,000 $15,000 d. $ 51,000 Residual income 10-45 Quick Check  If the manager of the Redmond Awnings division is evaluated based on residual income, will she want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year? a. Yes b. No 10-46 Quick Check  If the manager of the Redmond Awnings division is evaluated based on residual income, will she want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year? a. Yes Net operating income $78,000 b. No Required return (15% of $400,000) 60,000 Residual income $18,000 Residual income increases $3,000. 10-47 Divisional Comparisons and Residual Income The residual income approach has one major disadvantage. It cannot be used to compare performance of divisions of different sizes. 10-48 Zepher, Inc. - Continued Recall the following information for the Retail Division of Zepher, Inc. Assume the following information for the Wholesale Division of Zepher, Inc. Retail Wholesale Operating assets $ 100,000 $ 1,000,000 Required rate of return × 20% 20% Minimum required return $ 20,000 $ 200,000 Retail Wholesale Actual income $ 30,000 $ 220,000 Minimum required return (20,000) (200,000) Residual income $ 10,000 $ 20,000 10-49 Zepher, Inc. - Continued The residual income numbers suggest that the Wholesale Division outperformed the Retail Division because its residual income is $10,000 higher. However, the Retail Division earned an ROI of 30% compared to an ROI of 22% for the Wholesale Division. The Wholesale Division’s residual income is larger than the Retail Division simply because it is a bigger division. Retail Wholesale Operating assets $ 100,000 $ 1,000,000 Required rate of return × 20% 20% Minimum required return $ 20,000 $ 200,000 Retail Wholesale Actual income $ 30,000 $ 220,000 Minimum required return (20,000) (200,000) Residual income $ 10,000 $ 20,000 10-50 Transfer Prices – Key Concepts/Definitions A transfer price is the price charged when one segment of a company provides goods or services to another segment of the company. The fundamental objective in setting transfer prices is to motivate managers to act in the best interests of the overall company. 10-51 Transfer Prices – Key Concepts/Definitions There are three primary approaches to setting transfer prices: 1. Negotiated transfer prices 2. Transfers at the cost to the selling division 3. Transfers at market price 10-52