Chapter 22: Investment Centers

1. Return on Investment (ROI) ROI measures how effectively each division generates income relative to its assets. The formula is: ROI=IncomeAverage Assets • Example Calculation: o LCD Division: 750,0002,500,000=30% o Phone Division: 370,0001,850,000=20% These percentages indicate that the LCD division uses its assets more profitably (30%) compared to the Phone division (20%). 2. Residual Income (RI) Residual Income provides additional context by comparing each division’s income to a target return on assets, helping managers identify profitable opportunities that meet or exceed the target return. The formula is: Residual Income=Income−(Target Rate×Average Assets) • • Target Rate: Let’s assume management sets the target at 8% of average assets. Example Calculation: o LCD Division: 750,000−(0.08×2,500,000)=750,000−200,000=550,000 o Phone Division: 370,000−(0.08×1,850,000)=370,000−148,000=222,000 The LCD division has a higher residual income of $550,000, which suggests it is generating more income over the 8% target compared to the Phone division. 3. Profit Margin and Investment Turnover To further analyze ROI, we split it into two components: Profit Margin (efficiency in generating income from sales) and Investment Turnover (efficiency in generating sales from assets). • Profit Margin: Profit Margin=IncomeSales×100 Indicates income generated per dollar of sales. A higher profit margin shows better profitability. Investment Turnover: o • Investment Turnover=SalesAverage Assets Reflects how effectively the division uses assets to generate sales. A higher turnover indicates better asset utilization. Example Calculations: o If LCD division has $9,375,000 in sales and Phone division has $7,400,000:  LCD Profit Margin: 750,0009,375,000×100=8%  Phone Profit Margin: 370,0007,400,000×100=5%  LCD Investment Turnover: 9,375,0002,500,000=3.75  Phone Investment Turnover: 7,400,0001,850,000=4.0 o • In this case, the Phone division has a higher investment turnover (4.0 vs. 3.75), meaning it uses its assets more effectively to generate sales, but the LCD division has a higher profit margin (8% vs. 5%). 4. Interpreting Results • • ROI and Residual Income: While both metrics show the LCD division performs better financially, residual income adds a layer by showing absolute dollar contributions above the target rate, useful for deciding on new investment opportunities. Profit Margin and Investment Turnover: Splitting ROI into these components helps identify specific strengths: o The Phone division excels in asset turnover, suggesting efficiency in generating sales from assets. o The LCD division has a better profit margin, indicating stronger profitability on each sale. Summary Table Metric LCD Division Phone Division 30% 20% ROI $550,000 $222,000 Residual Income 8% 5% Profit Margin 4.0 Investment Turnover 3.75 Key Takeaways 1. LCD’s Higher Profitability: Its ROI and residual income are higher, and it has a stronger profit margin. 2. Phone’s Asset Efficiency: The higher investment turnover shows it effectively uses assets for generating sales. 3. Strategic Decisions: Using residual income encourages managers to accept projects exceeding the target return (8%), even if it may lower overall ROI, aligning with company value maximization. These analyses are essential for strategic planning, investment decision-making, and evaluating the effectiveness of division management in using assets to generate returns.