Question 1

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?

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.

Question 2

Residual income is a performance evaluation that is used in conjunction with,or instead of,return on investment (ROI).In many cases,residual income is preferred to ROI because (CIA adapted)

Accepted Answer

Residual income focuses on maximizing absolute dollars of income, which aligns with the goal of increasing overall wealth, whereas ROI focuses on percentage returns, which may not always align with maximizing total income.

Question 3

REB Service Co.is a computer service center.For the month of May,REB had the following operating statistics: (CMA adapted) Based on the above information,which one of the following statements is correct? REB has a

Accepted Answer

The answer of REB Service Co.is a computer service center.For...

Question 4

Explain the difference between the gross margin ratio,the operating margin ratio,and the profit margin ratio.

Accepted Answer

The answer of Explain the difference between the gross margin...

Question 5

The following information pertains to Quest Co.'s Gold Division for the current year: (CPA adapted) Quest's return on investment was

Accepted Answer

The answer of The following information pertains to Quest Co.'s...

Question 6

Residual income is a better measure for performance evaluation of an investment center manager than return on investment because (CMA adapted)

Accepted Answer

Return on investment measures the profitability of an investment center manager based on the ratio of income to assets invested, but it does not take into account the level of investment required to generate that income. A manager may be generating a high return on investment but may be neglecting necessary investments or projects that could create even higher returns. Residual income, on the other hand, measures the income generated by an investment center manager less a charge for the assets used in generating that income. This eliminates the problems associated with measuring the asset base and arguments about the implicit cost of interest, while also providing a better measure of the manager's ability to make profitable investment decisions. Therefore, residual income is a better measure for performance evaluation of an investment center manager than return on investment.

Question 7

Explain how using gross book value to measure the assets gives different results than using net book value.What happens to ROI over time under each of the two measures?

Accepted Answer

The answer of Explain how using gross book value to...

Question 8

Describe the two main limitations of return on investment.

Accepted Answer

The answer of Describe the two main limitations of return...

Question 9

What are two disadvantages of using divisional income as a performance measure?

Accepted Answer

The answer of What are two disadvantages of using divisional...

Quiz 14: Business Unit Performance Measurement

Residual income is a performance evaluation that is used in conjunction with,or instead of,return on investment (ROI) .In many cases,residual income is preferred to ROI because (CIA adapted)