James Webb is the general manager of the Industrial Product Division,and his performance is measured using the residual income method.Webb is reviewing the following forecasted information for his division for next year: (CMA adapted) If the cost of capital is 15% and Webb wants to achieve a residual income target of $2,000,000,what will costs have to be in order to achieve the target?
A)$9,000,000
B)$10,800,000
C)$25,150,000
D)$25,690,000

Question

Quizplus · Accepted Answer

Residual income can be calculated as net operating income (NOI) minus a charge for the opportunity cost of invested capital (i.e. the cost of capital multiplied by the division's average operating assets). 
Residual Income = NOI - (Cost of Capital * Average Operating Assets)
Given that Webb wants to achieve a residual income target of $2,000,000 and the cost of capital is 15%, we can set up the equation as follows:
$2,000,000 = NOI - (0.15 * Average Operating Assets)
Rearranging the equation, we get:
NOI = $2,000,000 + (0.15 * Average Operating Assets)
We are given the following forecasted information for the division for next year, which includes the expected operating income and operating assets:
Revenue: $30,000,000
Variable costs: $15,000,000
Fixed costs: $7,000,000
Average operating assets: $100,000,000
Operating income can be calculated as follows:
Operating Income = Revenue - Variable Costs - Fixed Costs
Operating Income = $30,000,000 - $15,000,000 - $7,000,000 = $8,000,000
Substituting the values into the equation for NOI, we get:
$8,000,000 = NOI - (0.15 * $100,000,000)
NOI = $8,000,000 + $15,000,000 = $23,000,000
Therefore, in order to achieve a residual income target of $2,000,000 and with a cost of capital of 15%, the costs would have to be:
Costs = Revenue - Operating Income
Costs = $30,000,000 - $23,000,000 = $7,000,000
However, the question is asking for costs, rather than revenues minus operating income. Therefore, we need to add back the fixed costs to get the total costs:
Total Costs = Variable Costs + Fixed Costs
Total Costs = $15,000,000 + $7,000,000 = $22,000,000
Therefore, the costs will have to be $22,000,000 in order to achieve the target residual income. Option C is the closest to this value with $25,150,000, which is the best choice.

James Webb Is the General Manager of the Industrial Product