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

2024
Views:

483

Pages:

26
Author:

Kaylyn Rocha

Chapter 10 Segment Reporting, Decentralization, and the Balanced Scorecard Part 3 10-44 Learning Objective 2 Compute return on investment (ROI) and show how changes in sales, expenses, and assets affect ROI. 10-45 Return on Investment (ROI) Formula Income before interest and taxes (EBIT) Net operating income ROI = Average operating assets Cash, accounts receivable, inventory, plant and equipment, and other productive assets. 10-46 Net Book Value versus Gross Cost Most companies use the net book value of depreciable assets to calculate average operating assets. Acquisition cost Less: Accumulated depreciation Net book value 10-47 Understanding ROI Net operating income ROI = Average operating assets Net operating income Margin = Sales Sales Turnover = Average operating assets ROI = Margin × Turnover 10-48 Increasing ROI There are three ways to increase ROI . . . Reduce Increase Expenses Reduce Sales Assets 10-49 Increasing ROI – An Example Regal Company reports the following: Net operating income Average operating assets Sales Operating expenses $ 30,000 $ 200,000 $ 500,000 $ 470,000 What is Regal Company’s ROI? ROI = Margin × Turnover ROI = Net operating income Sales × Sales Average operating assets 10-50 Increasing ROI – An Example ROI = Margin × Turnover ROI = Net operating income Sales ROI = $30,000 $500,000 × Sales Average operating assets $500,000 × $200,000 ROI = 6% × 2.5 = 15% 10-51 Investing in Operating Assets to Increase Sales Suppose that Regal's manager invests in a $30,000 piece of equipment that increases sales by $35,000, while increasing operating expenses by $15,000. Regal Company reports the following: Net operating income Average operating assets Sales Operating expenses $ 50,000 $ 230,000 $ 535,000 $ 485,000 Let’s calculate the new ROI. 10-52 Investing in Operating Assets to Increase Sales ROI = Margin × Turnover ROI = Net operating income Sales $50,000 ROI = $535,000 × Sales Average operating assets $535,000 × $230,000 ROI = 9.35% × 2.33 = 21.8% ROI increased from 15% to 21.8%. 10-53 Criticisms of ROI In the absence of the balanced scorecard, management may not know how to increase ROI. Managers often inherit many committed costs over which they have no control. Managers evaluated on ROI may reject profitable investment opportunities. 10-54 Learning Objective 3 Compute residual income and understand its strengths and weaknesses. 10-55 Residual Income - Another Measure of Performance Net operating income above some minimum required return on operating assets 10-56 Calculating Residual Income Residual = income Net operating income ( Average operating assets × ) Minimum required rate of return 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. 10-57 Residual Income – An Example • The Retail Division of Zephyr, 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. 10-58 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 10-59 Motivation and Residual Income Residual income encourages managers to make investments that are profitable for the entire company but would be rejected by managers who are evaluated using the ROI formula. 10-60 Quick Check  Redmond Awnings, a division of Wrap-up 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% 10-61 Quick Check  Redmond Awnings, a division of Wrap-up 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% ROI = NOI/Average operating assets = $60,000/$300,000 = 20% 10-63 Quick Check  Redmond Awnings, a division of Wrap-up 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 ROI = $78,000/$400,000 = 19.5% This lowers the division’s ROI from 20.0% down to 19.5%. 10-65 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? ROI = $18,000/$100,000 = 18% a. Yes b. No The return on the investment exceeds the minimum required rate of return. 10-67 Quick Check  Redmond Awnings, a division of Wrap-up 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 Net operting income Required return (15% × $300,000) Residual income $ 60,000 (45,000) $ 15,000 10-69 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 Net operting income Required return (15% × $400,000) Residual income $ 78,000 (60,000) $ 18,000 Yields an increase of $3,000 in residual income 10-70 Divisional Comparisons and Residual Income The residual income approach has one major disadvantage. It cannot be used to compare the performance of divisions of different sizes. 10-71 Zephyr, Inc. - Continued Recall the following information for the Retail Division of Zephyr, Inc. Assume the following information for the Wholesale Division of Zephyr, Inc. Retail Wholesale $ 100,000 $ 1,000,000 Operating assets 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 10-72 Zephyr, 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