Business Unit Performance Measurement: True / False Questions

Chapter 14
Business Unit Performance Measurement

True / False Questions

1. Divisional income statements do not have to follow generally accepted accounting principles (GAAP)
because they are internal reports.

True False

2. One advantage of using after-tax income as a performance measure of divisional results is that it is a
financial accounting measure that can also be used to compute organizational income.

True False

3. One disadvantage of using after-tax income as a performance measure of divisional results is that it is an
absolute measure which makes it difficult to compare divisions of significantly different sizes.

True False

4. The profit margin ratio is computed by dividing after-tax operating income by sales.

True False

5. In general, it is better to have a higher return on investment (ROI) than a lower one.

True False

6. One problem associated with using accounting measures to evaluate divisional performance is the measures
are based on historical information.

True False

7. A problem with ratio-based measures is that managers can make decisions that improve divisional income
but lower total organizational income.

True False

8. It is not possible for a manager to accept an unacceptable project when his/her performance is evaluated
using ROI.

True False

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McGraw-Hill Education.
9. Residual income is the difference between the divisional income and the cost of invested capital required to
operate the division.

True False

10. The use of residual income reduces, but does not eliminate, the suboptimization problem.

True False

11. Managerial myopia is the distortion in incentives that result from using accounting measures to evaluate
performance.

True False

12. Most organizations use residual income instead of return on investment (ROI) as a performance measure.

True False

13. Economic value added (EVA) adjustments are made to both the after-tax income and the capital employed.

True False

14. Treating research and development costs as an expense rather than a long-term asset may reduce a
manager's inclination to participate in research and development activities.

True False

15. One problem with economic value added (EVA) adjustments is determining the appropriate life for
expenditures that benefit multiple periods.

True False

16. Like return on investment (ROI), economic value added (EVA) adjustments fail to sufficiently address the
sub-optimization problem.

True False

17. In general, a division's investment base includes an allocated share of the corporate headquarters' assets.

True False

18. Using net book values instead of gross book values to compute return on investment (ROI) might
encourage an investment center manager to delay replacing inefficient assets until they are fully
depreciated.

True False

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19. Current costs should not be used to compute either return on investment (ROI) or residual income because
current costs are not generally accepted accounting principles (GAAP).

True False

20. Historical costs are based on the original costs to acquire a long-term asset, while current costs represent
the costs to replace the long-term asset.

True False

Multiple Choice Questions

21. Which of the following is not an advantage of after-tax income as a performance measure?

A. It reflects the results of decisions under the division manager's control.
B. It summarizes the results of decisions affecting revenues and costs.
C. It makes comparison of divisions easy because they use the same measure, dollars of income.
D. Financial accounting income at the divisional level is computed differently from that of the income for
the firm.

22. Which of the following statements is(are) true?
(A) Divisional income statements do not include allocated common costs.

(B) The gross margin ratio is computed by dividing operating income by sales.

A. Only A is true.
B. Only B is true.
C. Both A and B are true.
D. Neither A nor B is true.

23. After-tax income divided by sales is called the:

A. gross margin ratio.

B. profit margin ratio.
C. operating margin ratio.
D. contribution margin ratio.

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24. The measure (ratio) that reflects the performance of a manager regarding sales and cost of goods sold, but
not other operating costs and income taxes, is called the:



25. If a division is evaluated using return on investment (ROI) without regard to how assets are financed, the
denominator in the ROI calculation will be:

A. current assets.
B. working capital.
C. total assets available.
D. total assets employed.

26. Return on investment (ROI) can be decomposed into the asset turnover and the:



27. The asset turnover is a measure (ratio) of an investment center's ability to:

A. earn profits.
B. generate sales.
C. control costs.
D. remain solvent.

28. Which of the following statements does not represent a limitation of using return on investment (ROI) for
measuring and evaluating performance?

A. ROI uses accounting income which is based on historical costs.

B. ROI cannot be used to compare divisions of different sizes.
C. ROI has the potential to create goal congruence problems.
D. ROI fails to align some costs incurred in one period with the benefits received in another period.

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29. How will increases in the following items affect return on investment (ROI)?

Expenses Inventory
A. Decrease Decrease
B. Decrease Increase
C. Increase Decrease
D. Increase Increase

A. Option A
B. Option B
C. Option C
D. Option D

30. A manager can always increase his/her return on investment (ROI) by:

A. reducing the asset turnover.

B. decreasing residual income.
C. increasing the operating profit margin.
D. expanding operating assets while holding sales and expenses constant.

31. The Maxim Corporation reported the following operating results for its three divisions: South, West, and
East.
South West East

Division Division Division
Sales $380,000 $1,700,000 $2,000,000
Operating
$20,000 $50,000 $100,000
profits
Divisional
$200,000 $625,000 $800,000
assets
Which division has the smallest return on investment (ROI)?

A. South.
B. West.
C. East.
D. All three divisions are the same.

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East.
South West East

Sales $380,000 $1,700,000 $2,000,000
Operating
$20,000 $50,000 $100,000
profits
Divisional
$200,000 $625,000 $800,000
assets
Which division has the largest asset turnover?

A. South.
B. West.
C. East.

East.
South West East

Sales $380,000 $1,700,000 $2,000,000
Operating
$20,000 $50,000 $100,000
profits
Divisional
$200,000 $625,000 $800,000
assets
Which division's profit margin is the highest?

A. South.
B. West.
C. East.

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34. The following information was presented by User-Friendly Industries Company for an asset purchased at
the end of the previous year.
Original cost of the asset $20,000

Useful life of the asset 10 years
Annual operating profit, including depreciation $4,000
Salvage value $-0-
What is the return on investment (ROI) assuming User-Friendly (a) uses the straight-line method for
depreciation and (b) beginning-of-year net book values to compute ROI?

A. 11.1%.
B. 20.0%.
C. 22.2%.
D. 25.0%.

35. The following information was presented by Outdoors Manufacturing Company for an asset purchased at
the end of the previous year.

Cashflow annual operating profit $4,000
Salvage value $-0-
What is the return on investment (ROI) assuming Outdoors (a) uses the straight-line method for

A. 11.1%.
B. 20.0%.
C. 10.0%.
D. 22.2%.

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36. The following information was presented by Shower Wonder Enterprises for an asset purchased at the
beginning of the previous year.

Salvage value $-0-
What is the return on investment (ROI) assuming Shower Wonder (a) uses the straight-line method for
depreciation and (b) average net book values to compute ROI?

A. 21.1%.
B. 20.0%.
C. 22.2%.
D. 11.76%.

37. Garage Corporation's return on investment (ROI) on some new equipment was 20% using beginning-of-
year net book value. The gross book value of the equipment is $250,000. Accumulated depreciation at the
beginning of the year was $10,000. This represents one-half year's straight-line depreciation. What is the
annual before-tax cash flow from the new equipment?

A. $68,000.
B. $60,000.
C. $48,000.
D. $20,000.

38. Madrigal Corporation purchased a new machine for $120,000. The machine has an estimated useful life of
10-years with no salvage value and a return on investment (ROI) of 15%. ROI is computed using annual
cash flows and straight-line depreciation. What is the annual cash flow using the gross book value method?
A. $12,200.
B. $18,000.
C. $28,200.
D. $30,000.

39. The Nacho Division of the Tex-Mex Company has a return on investment (ROI) of 12%, sales of $200,000,
and an asset turnover of 2.0. What was Nacho's operating income?

A. $6,000.
B. $12,000.
C. $24,000.
D. $48,000.

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40. The following information is available for Sweet Dreams Company:
Sales $100,000
Operating expenses $94,000
Operating assets $40,000
Stockholder’s equity $25,000
Cost of capital 10%
What is Sweet Dreams Company's return on investment (ROI)?

A. 6.0%.
B. 10.0%.
C. 15.0%.
D. 24.0%.

41. The Gallop Company has an asset turnover of 3.0 times, using assets of $45,000. The company also has a
return on investment (ROI) of 20%. What was Gallop's operating profit margin?

A. 5.0%.
B. 6.0%.
C. 6.7%.
D. 8.3%.

42. How will decreases in the following items affect return on investment (ROI)?
Sales Equipment

A. Option A
B. Option B
C. Option C
D. Option D

43. A firm earning a profit can increase its return on investment by: (CMA adapted)

A. increasing sales revenue and operating expenses by the same dollar amount.
B. decreasing sales revenues and operating expenses by the same percentage.
C. increasing investment and operating expenses by the same dollar amount.
D. increasing sales revenues and operating expenses by the same percentage.

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44. Return on investment (ROI) is a very popular measure employed to evaluate the performance of corporate
segments because it incorporates all of the major ingredients of profitability (revenue, cost, investment)
into a single measure. Under which one of the following combinations of actions regarding a segment's
revenues, costs, and investment would a segment's ROI always increase? (CIA adapted)
Sales Equipment Investment

A. Increase Decrease Increase
B. Decrease Decrease Decrease
C. Increase Increase Increase
D. Increase Decrease Decrease

A. Option A
B. Option B
C. Option C
D. Option D

45. The following information pertains to Artemis Co. for the year ended December 31: (CPA adapted)
Sales $600,000
Income $100,000
Capital investment $400,000
Which of the following equations should be used to compute Artemis' return on investment (ROI)?

A. (4/6) × (6/1) = ROI

B. (6/4) × (1/6) = ROI
C. (4/6) × (1/6) = ROI
D. (6/4) × (6/1) = ROI

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46. The following information pertains to Zootime Co.'s Shelter Division for the current year: (CPA adapted)
Sales $311,000
Variable cost $250,000
Traceable fixed costs $50,000
Average invested capital $40,000
Imputed interest rate 10%
Zootime's return on investment was:

A. 10.00%.
B. 13.33%.
C. 27.50%.
D. 30.00%.

47. A division earning a profit will increase its return on investment (ROI) if it increases operating expenses
and:

A. sales by the same dollar amount.

B. sales by the same percentage.
C. investment by the same dollar amount.
D. investment by the same percentage.

48. In computing the margin in a ROI analysis, which of the following is used?

A. Sales in the denominator.

B. Net operating income in the denominator.
C. Average operating assets in the denominator.
D. Residual income in the denominator.

49. In determining the dollar amount to use for operating assets in the return on investment (ROI) calculation,
companies will generally use either net book value or gross cost of the assets. Which of the following is an
argument for the use of net book value rather than gross cost?

A. It is consistent with how assets are reported on the balance sheet.
B. It eliminates the depreciation method as a factor in ROI calculations.
C. It encourages the replacement of old, worn-out equipment.
D. all of the above.

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50. Average operating assets are $110,000 and net operating income is $23,100. The company invests $25,000
in new assets for a project that will increase net operating income by $4,750. What is the return on
investment (ROI) of the new project?

A. 21%.
B. 19%.
C. 18.5%.
D. 20%.

51. Last year a company had stockholders' equity of $160,000, net operating income of $16,000, and sales of
$100,000. The turnover was 0.5. The return on investment (ROI) was:

A. 10%.
B. 9%.
C. 8%.
D. 7%.

52. Sales and average operating assets for Wyeth Company and Genesis Company are given below:
Sales Average Operating Assets

Wyeth Company $20,000 $8,000
Genesis Company $50,000 $10,000
What is the margin that each company will have to earn in order to generate a return on investment of
20%?

A. 12% and 16%.

B. 50% and 100%.
C. 8% and 4%.
D. 2.5% and 5%.

53. Rex Company's sales last year totaled $150,000 and its return on investment (ROI) was 12%. If the
company's turnover was 3, then its net operating income for the year must have been:

A. $6,000.
B. $2,000.
C. $18,000.
D. it is impossible to determine from the data given.

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54. The Dry Wall Division reports the following operating data for the past two years:
Year 1 Year 2
Margin 16% ?
Turnover 2.5 2
Average operating assets ? $150,000
Net operating income $40,000 ?
Stockholders’ equity $80,000 $125,000
Sales ? ?
The return on investment at the Dry Wall Division was exactly the same in Year 1 and Year 2.
The margin in Year 2 was:

A. 48%.
B. 32%.
C. 20%.
D. 10%.

Year 1 Year 2
Margin 16% ?
Turnover 2.5 2
Sales ? ?
Sales in Year 2 amounted to:

A. $250,000.
B. $300,000.
C. $325,000.
D. $350,000.

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Year 1 Year 2
Margin 16% ?
Turnover 2.5 2
Sales ? ?
Average operating assets in Year 1 were:

A. $160,000.
B. $150,000.
C. $125,000.
D. $100,000.

Year 1 Year 2
Margin 16% ?
Turnover 2.5 2
Sales ? ?
Net operating income in Year 2 amounted to:

A. $60,000.
B. $50,000.
C. $40,000.
D. $35,000.

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58. The following data are available for the South Division of Manhattan Products, Inc. and the single product
it makes:
Unit selling price $20

Variable cost per unit $12
Annual fixed costs $280,000
Average operating assets $1,500,000
How many units must South sell each year to have an ROI of 16%?

A. 240,000.
B. 1,300,000.
C. 52,000.
D. 65,000.

59. The Country Garden Company's current net operating income is $16,800 and its average operating assets
are $80,000. The Country Garden's required rate of return is 18%. A new project being considered would
require an investment of $15,000 and would generate annual net operating income of $3,000. What is the
residual income of the new project?

A. 20.8%.
B. 20%.
C. $(150).
D. $300.

60. Imagination Corporation uses residual income to evaluate the performance of its divisions. Imagination's
minimum required rate of return is 11%. In April, the Commercial Products Division had average operating
assets of $100,000 and net operating income of $9,400. What was the Commercial Products Division's
residual income in April?

A. $(1,600).
B. $1,600.
C. $1,034.
D. $(1,034).

61. Division B had an ROI last year of 15%. The division's minimum required rate of return is 10%. If the
division's average operating assets last year were $450,000, then the division's residual income for last year
was:

A. $67,500.
B. $22,500.
C. $37,500.
D. $45,000.

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62. Which of the following will not result in an increase in the residual income, assuming other factors remain
constant?

A. An increase in sales.

B. An increase in the minimum required rate of return.
C. A decrease in expenses.
D. A decrease in operating assets.

63. All other things the same, which of the following would increase residual income?

A. Increase in average operating assets.

B. Decrease in average operating assets.
C. Increase in minimum required return.
D. Decrease in net operating income.

64. Which of the following statement(s) is/are true?
(A) If a division's return on investment (ROI) exceeds its cost of capital, then its residual income is
positive.
(B) If a division's cost of capital equals its return on investment (ROI), then its residual income is zero.

A. Only (A) is true.

B. Only (B) is true.
C. Both (A) and (B) are true.
D. Neither (A) and (B) is true.

65. Residual income is similar to the _________ notion of profit as being the amount left over after all costs,
including the cost of the capital employed in the division, are subtracted.

A. accountant's
B. manager's
C. shareholder's
D. economist's

66. Which of the following statement(s) is/are false?
(A) Residual income can be used to compare divisions of different sizes.

(B) Residual income can be used to compare divisions that are profit centers.

A. Only (A) is false.

B. Only (B) is false.
C. Both (A) and (B) are false.
D. Neither (A) and (B) is false.

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67. Managerial performance can be measured in many different ways including return on investment (ROI) and
residual income. A good reason for using residual income instead of ROI is that:

A. residual income can be computed without regard to identifying an investment base.

B. appropriate goal congruence behavior is more likely to occur when using residual income.
C. residual income is well accepted in many organizations and often used in the financial press.
D. ROI does not take into consideration both the investment turnover ratio and return-on-sales percentage.

68. How will decreases in the following items affect residual income?

Expenses Inventory

A. Option A
B. Option B
C. Option C
D. Option D

69. 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)

A. residual income is a measure over time, while ROI represents the results for one period.
B. residual income concentrates on maximizing absolute dollars of income rather than a percentage return,
as with ROI.
C. the imputed interest rate used in calculating residual income is more easily derived than the target rate
that is compared to the calculated ROI.
D. average investment is employed with residual income while year-end investment is employed with ROI.

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

A. the problems associated with measuring the asset base are eliminated.
B. desirable investment decisions will not be neglected by high-return divisions.
C. only the gross book value of assets needs to be calculated.
D. the arguments about the implicit cost of interest are eliminated.

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71. Kevin Thomas is the general manager of the Modular Homes Division, and his performance is measured
using the residual income method. Thomas is reviewing the following forecasted information for his
division for next year: (CMA adapted)
Amount
Category (thousands)
Working capital $1,800
Revenue 30,000
Plant and equipment 17,200
If the cost of capital is 15% and Thomas 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.

72. Bella Vista Service Co. is a computer service center. For the month of May, Bella Vista Service Co. had the
following operating statistics: (CMA adapted)
Sales $450,000
Operating income 25,000
Net profit after taxes 8,000
Total assets 500,000
Stockholder’s equity 200,000
Cost of capital 6%
Based on the above information, which one of the following statements is correct?

A. Bella Vista Service Co. has a return on investment of 4%.

B. Bella Vista Service Co. has a residual income of $(2,000).
C. Bella Vista Service Co. has a return on investment of 5.6%.
D. Bella Vista Service Co. has a residual income of $(22,000).

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73. How will increases in the following items affect residual income?
Sales Equipment

A. Option A
B. Option B
C. Option C
D. Option D

74. Which of the following should not be used for the cost of capital to compute residual income?

A. Historical weighted average cost of capital.

B. Marginal after-tax cost of new equity capital.
C. Cost of debt and equity used to finance a project.
D. Return on investment (ROI).

75. Which one of the following items would most likely not be incorporated into the calculation of a division's
investment base when using the residual income approach for performance measurement and evaluation?

A. Land being held by the division as a potential site for a new plant and parking lot.
B. Division inventories when division management exercises control over the inventory levels.
C. Division accounts payable when division management exercises control over the amount of short-term
credit utilized.
D. Division accounts receivable when division management exercises control over credit policy and credit
terms.

76. The Pathways Company has an asset turnover of 3.0 times, using assets of $45,000. The company also has
a return on investment (ROI) of 20%. If the residual income was $2,250, what was the company's cost of
capital?

A. 6.0%.
B. 10.0%.
C. 15.0%.
D. 20.0%.

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77. In 2016, Evans Corporation had an operating profit of $750,000 and a residual income of $300,000. If
Evans' cost of capital is 15%, what is the amount of the invested capital?

A. $5,000,000.
B. $3,000,000.
C. $2,000,000.
D. $1,250,000.

78. The following information is available for Kiss Company:
Sales $100,000
Cost of capital 10%
What is Kiss Company's residual income?

A. $2,000.
B. $2,500.
C. $3,500.
D. $4,000.

79. The following information has been gathered for the Door Division:
Return on investment (ROI) 15.0%

Sales $120,000
Cost of Capital 12.0%
Profit margin 7.5%
Compute the Door Division's residual income.

A. $1,800.
B. $2,700.
C. $3,600.
D. $5,400.

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80. Use the following information to compute residual income:
Sales $320,000
Operating income $60,000
Average current assets $250,000
Cost of capital 12%
Return on investment 15%

A. $12,000.
B. $22,500.
C. $30,000.
D. $48,000.

81. The Labrador Falls Company has three divisions: A Division, B Division, and C Division.
A B C
Sales $320,000 $540,000 ?
Net operating income 60,000 ? $24,000
Residual income ? 36,000 14,400
Average Division
250,000 320,000 80,000
Assets
Cost of Capital 12% 16%
Profit Margin 20% 5%
Asset Turnover ? 4.0
What was A Division's residual income last year?

A. $12,000.
B. $22,500.
C. $30,000.
D. $48,000.

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A B C
Sales $320,000 $540,000 ?
Average Division
250,000 320,000 80,000
Assets
What was B Division's return on investment (ROI) last year?

A. 16.00%.
B. 20.00%.
C. 24.00%.
D. 33.75%.

A B C
Sales $320,000 $540,000 ?
Average Division
250,000 320,000 80,000
Assets
What was C Division's cost of capital last year?

A. 8%.
B. 12%.
C. 18%.
D. 20%.

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return on investment (ROI) because: (CMA adapted)

B. desirable investment decisions will not be neglected by high return divisions.
D. returns do not increase as assets are depreciated.

85. Which one of the following items would most likely not be incorporated into the calculation of a division's
investment base when using the residual income approach for performance measurement and evaluation?
(CMA adapted)

A. Fixed assets employed in division operations.

B. Land being held by the division as a site for a new plant.
C. Division inventories when division management exercises control over the amount of short-term credit
used.
D. Division accounts payable when division management exercises control over the amount of short-term
credit used.


B. desirable investment decisions will not be rejected by divisions that already have a high ROI.

87. Which of the following items would not be an example of an economic value added (EVA) adjustment to
eliminate accounting distortions?

A. Research & development costs.

B. Advertising expenditures.
C. Patent amortization.
D. Common stock.

88. Which of the following items would not require an adjustment to capital employed when using economic
value added (EVA)?


C. Preferred stock.
D. Patents developed.

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89. Economic value added (EVA) is a concept that is closely related to residual income. EVA is computed by:

A. subtracting the adjusted total cost of capital from the adjusted after-tax income.
B. subtracting adjusted after-tax income from total divisional investment.
C. dividing adjusted after-tax income by adjusted divisional investment.
D. dividing adjusted after-tax income by adjusted total cost of capital.

90. Economic value added (EVA) assumes that which of the following GAAP expenses would not result in an
adjustment to either the income or the capital employed?


B. Use of process costing rather than job costing.
C. Advertising expenses.
D. Writeoff of goodwill.

91. Which of the following statements regarding the use of historical costs and current costs to compute return
on investment (ROI) is(are) true?
(A) Historical costs are based on the original costs to acquire a long-term asset, while current costs
represent the costs to replace the long-term asset.
(B) For a specific multiple-period project, the return on investment (ROI) computed using current costs
will generally be less than the ROI computed using historical costs.



92. Level return on investments (ROI) over the life of a long-term project is more likely when ROI is computed
using:

A. historical costs and net book values.

B. historical costs and gross book values.
C. current costs and net book values.
D. current costs and gross book values.

93. Using ending balances for the investment base in computing return on investment (ROI) might encourage
managers to acquire assets:

A. early in the year and dispose of assets late in the year.

B. early in the year and dispose of assets early in the year.
C. late in the year and dispose of assets late in the year.
D. late in the year and dispose of assets early in the year.

14-24
94. Using beginning balances for the investment base in computing return on investment (ROI) might
encourage managers to acquire assets:



95. One division of the Marvin Educational Enterprises has depreciable assets costing $4,000,000. The cash
flows from these assets for the past three years have been:
Year Cash flows

1 $1,200,000
2 $1,400,000
3 $1,620,000
The current (i.e., replacement) costs of these assets were expected to increase 25% each year. Marvin used
the straight-line depreciation method; the estimated useful life is 10-years with no salvage value. For return
on investment (ROI) calculations, Marvin uses end-of-year balances.
What is the ROI using historical cost and gross book value?
Year 1 Year 2 Year 3

A. 20.0% 25.0% 30.5%
B. 25.0% 28.0% 32.0%
C. 18.0% 26.5% 28.0%
D. 30.0% 35.0% 40.5%

A. Option A
B. Option B
C. Option C
D. Option D

14-25
Year Cash flows

1 $1,200,000
2 $1,400,000
3 $1,620,000
What is the ROI using historical cost and net book value?

A. 21.5% 34.0% 42.0%
B. 22.2% 31.3% 43.6%
C. 23.0% 32.0% 47.0%
D. 24.8% 35.0% 49.5%

A. Option A
B. Option B
C. Option C
D. Option D

14-26
Year Cash flows

1 $1,200,000
2 $1,400,000
3 $1,620,000
What is the ROI using current costs and gross book value?

A. 14.0% 18.0% 22.4%
B. 13.0% 14.0% 14.0%
C. 12.0% 10.1% 9.5%
D. 14.0% 12.4% 10.7%

A. Option A
B. Option B
C. Option C
D. Option D

14-27
Year Cash flows

1 $1,200,000
2 $1,400,000
3 $1,620,000
What is the ROI using current costs and net book value?

A. 14.6% 15.9% 16.0%
B. 15.8% 15.9% 14.9%
C. 15.6% 15.5% 15.3%
D. 15.6% 15.8% 11.9%

A. Option A
B. Option B
C. Option C
D. Option D

14-28
Year Cash flows

1 $1,200,000
2 $1,400,000
3 $1,620,000
What is the residual income for each year, assuming the cost of capital is 15% and Marvin uses historical
costs and gross book values to compute residual income?

A. $200,000 $400,000 $620,000
B. $200,000 $200,000 $200,000
C. $250,000 $200,000 $450,000
D. $250,000 $400,000 $375,000

A. Option A
B. Option B
C. Option C
D. Option D

14-29
Year Cash flows

1 $1,200,000
2 $1,400,000
3 $1,620,000
What is the residual income for each year, assuming the cost of capital is 15% and Marvin uses historical
costs and net book values to compute residual income?

A. $200,000 $435,000 $690,000
B. $260,000 $520,000 $800,000
C. $260,000 $420,000 $540,000
D. $280,000 $400,000 $750,000

A. Option A
B. Option B
C. Option C
D. Option D

14-30
101. The Jones Company purchased assets costing $200,000 which will be depreciated over 5-years using
straight-line depreciation and no salvage value. The Jones also purchased land and other assets, which are
not depreciable at a cost of $200,000. It is estimated that in 5-years, the value of these assets will be
unchanged. Assume that annual cash profits are $80,000 and, for return on investment (ROI) calculations,
the company uses end-of-year asset values.
What is the ROI for each year using net book value?
Year 1 Year 2 Year 3 Year 4

A. 11.1% 12.5% 14.3% 16.7%
B. 10.0% 10.0% 10.0% 10.0%
C. 10.0% 8.9% 7.3% 6.5%
D. 11.1% 11.5% 12.5% 12.3%

A. Option A
B. Option B
C. Option C
D. Option D

What is the ROI for each year using gross book value?

A. 10.0% 9.5% 8.0% 7.9%
B. 10.0% 10.0% 10.0% 10.0%
C. 12.5% 11.0% 12.0% 15.0%
D. 10.0% 12.5% 14.0% 17.0%

A. Option A
B. Option B
C. Option C
D. Option D

14-31
If sales each year average $840,000, what will be the asset turnover using gross book value?

A. 3.0.
B. 2.6.
C. 2.1.
D. 1.9.

Essay Questions

104. Seaside Enterprises has the following data for its three divisions for the year:
SB TH GM
Revenues $1,200,000 $3,800,000 $2,800,000
Cost of sales 769,500 1,900,000 1,400,000
Allocated
corporate 72,000 228,000 210,000
overhead
Other general &
158,500 1,100,000 1,100,000
administration
Required:
a. Compute divisional operating income for each of the divisions. Assume taxes are 30%.
b. Calculate the gross margin ratio for each division.
c. Calculate the operating margin ratio for each division.
d. Calculate the profit margin ratio for each division.

14-32
105. La Mesa Foods has the following data for its two divisions for the year:
Uno Dos
Revenues $600,000 $1,900,000
Cost of sales 384,750 950,000
Allocated corporate overhead 36,000 114,000
Other general & administration 79,250 550,000
Required:

14-33
106. Nue Wines has the following data for its three divisions for the year:
Ein Zwei Drei

Revenues $12,000,000 $38,000,000 $28,000,000
Cost of sales 7,695,000 19,000,000 14,000,000
Allocated
corporate 720,000 2,280,000 2,100,000
overhead
Other general
& 1,585,000 11,000,000 11,000,000
administration
Return on
15% 12% 9%
Investment
Required:
b. Calculate the profit margin ratio for each division.
c. Calculate the asset turnover for each division.

14-34
107. La Mesa Stores has the following data for its two divisions for the year:
Uno Dos
Revenues $6,000,000 $18,000,000
Cost of sales 3,769,500 9,400,000
Allocated corporate overhead 400,000 1,200,000
Other general &
772,000 5,700,000
administration
Return on Investment 14% 12%
Required:

14-35
108. The Calculating Fashion Company has two operating divisions: North and South. The following
information was collected from its financial statements.
North South
Operating income $15,375 $9,160
Sales 90,100 128,445
Average operating assets 47,620 37,690
Required:
Compute the following ratios for each division:
a. Profit margin
b. Asset turnover
c. Return on investment (ROI)

14-36
North South
Sales 90,100 128,445
Required:
The South Division has a goal to increase its ROI to 30% by the end of next year. Compute the increase
(decrease) required in each of the following items in order to achieve this goal.
a. Operating assets
b. Total costs
c. Sales

14-37
110. You are the manager of an operating division of a manufacturing company. Your division has $4,500,000
in assets, and your budgeted income statement for the current year follows:
Revenues $8,000,000
Cash costs:
Variable 1,000,000
Fixed 3,750,000
Depreciation 1,375,000
Your company uses a performance evaluation and bonus plan, which is based on return on investment
(ROI) computed with end-of-year gross asset balances.
In October, you discover that you can purchase a new machine for $3,250,000, which will enable you to
expand the output of your division and save costs. The machine would have a salvage value of $250,000
and would be depreciated over 3-years using the straight-line method. It will increase output by 10% while
reducing cash fixed costs by 5%. If you accept the machine, it will be installed in late December, but no
depreciation will be taken on the new machine this year.
If you do buy this machine, you will have to dispose of the machine you are now using, which you just
purchased last January. That machine cost you $2,500,000 but has no salvage value. $750,000 of the
depreciation on the income statement is depreciation for this machine. In the ROI calculations, the
company includes any gains or losses for equipment disposal in income for the year. You may safely
ignore all taxes for this analysis.
Required:
a. What is your division's ROI this year if you do not acquire the new machine?
b. What is your division's ROI this year if you do acquire the new machine?
c. What is your division's expected ROI next year if the machine is acquired and meets expectations?

14-38
111. The ArtMart Company has three divisions: X Division, Y Division, and Z Division. Operating results for
the three divisions for last year were as follows:
Div X Div Y Div Z

Residual income $98,400 $27,200 $2,000
Net operating income 188,600 115,600 66,000
Average operating
820,000 680,000 400,000
assets
Sales 1,640,000 1,445,000 1,040,000
Profit margin 11.5% 8.0% 5.0%
Corporate headquarters is offering an investment opportunity to each of the divisions. The opportunity will
yield an operating income of $35,000, based on an average operating investment of $246,000.
Required:
a. If the divisions are being evaluated using return on investment (ROI), what will be the decision (accept
or reject) of each division regarding this opportunity? Support your answer with the appropriate
calculations.
b. If the divisions are being evaluated using residual income, what will be the decision (accept or reject) of
each division regarding this opportunity? Support your answer with the appropriate calculations.

14-39
112. The following information is available about the status and operations for Division A of Boxwood
Company, which has a minimum required ROI of 20%. Answer each item independently of the others.
Division A
Divisional investment $200,000
Divisional profit $70,000
Divisional sales $400,000
Required:
a. Compute the ROI for Division A.

b. Division A could increase its profit by $16,000 by increasing its investment by $60,000. Compute its
new ROI.
c. Division A could increase its profit margin ratio by one percentage point (for example: from 12% to
13%), without increasing total sales or investment. Compute its new ROI.
d. Division A could reduce its investment so that its asset turnover increased by one time, while holding
total sales and profit constant. Compute its new ROI.

14-40
113. The following information is available about the status and operations for Division B of Boxwood
Division B
Divisional investment $1,500,000
Divisional sales $3,600,000
Required:
a. Compute the ROI for Division B.

b. Division B could increase its profit by $25,000 by increasing its investment by $100,000. Compute its
new ROI.
c. Division B could increase its profit margin ratio by one percentage point (for example: from 13% to
d. Division B could reduce its investment so that its asset turnover increased by one time, while holding

114. Radner Industries is a division of a major corporation. Last year the division had total sales of $23,380,000,
net operating income of $2,828,980, and average operating assets of $7,000,000. The company's minimum
required rate of return is 12%.
Required:
a. What is the division's margin?

b. What is the division's turnover?
c. What is the division's return on investment (ROI)?

14-41
115. Danali Fabrication is a division of a major corporation. Last year the division had total sales of
$21,120,000, net operating income of $2,006,400, and average operating assets of $6,000,000. The
company's minimum required rate of return is 12%.
Required:
What is the division's return on investment (ROI)?

116. The following information is available about the Appliance Division of Rainier Company.
Rainier requires a return of 9% from all divisions.
Appliance Division
$18,462,000
Earnings from Operations
Appliance Division Sales $112,600,000
Appliance Division
$173,700,000
Identifiable Assets
Required:
(use four decimal places in your calculation)
a. Compute the ROI for the Appliance Division.

b. Compute the residual income for the Appliance Division.

14-42
117. Bleu Stone is a division of a major corporation. The following data are for the latest year of operations:
Sales $30,000,000
Net operating income $1,170,000
The company’s minimum required rate of
18%
return
Required:

d. What is the division's residual income?

Sales $33,040,000
18%
return
Required:
a. What is the division's return on investment (ROI)?

b. What is the division's residual income?

14-43
119. Edmonson Corporation had net operating income of $150,000 and average operating assets of $500,000.
The company requires a return on investment of 19%.
Required:
a. Calculate the company's current return on investment and residual income.

b. The company is investigating an investment of $400,000 in a project that will generate annual net
operating income of $78,000. What is the return on investment of the project? What is the residual income
of the project? Should the company invest in this project?

120. The following information is available about the Charger Division of Weston Company. Weston requires a
return of 8% from all divisions.
Charger Division Earnings from

$12,854,000
Operations
Charger Division Sales $92,500,000
Charger Division Identifiable Assets $156,000,000
Required:
(use four decimal places in you calculation)
a. Compute the ROI for the Charger Division.

b. Compute the residual income for the Charger Division.

14-44
121. The following information is available about the status and operations for Division A of Abad Company,
which has a minimum required ROI of 20%. Answer each item independently of the others.
Division A
Required:

b. Compute the residual income for Division A.
c. Division A could increase its profit by $8,000 by increasing its investment by $30,000. Compute its
total residual income.
d. Division A could increase its profit margin ratio by one percentage point (for example: from 12% to
e. Division A could reduce its investment so that its asset turnover increased by one time, while holding

14-45
122. The following information is available about the status and operations for Division B of Abad Company,
Division B
Required:

b. Compute the residual income for Division B.
c. Division B could increase its profit by $10,000 by increasing its investment by $40,000. Compute its
d. Division B could increase its return on sales by one percentage point (for example: from 10% to 11%),
without increasing total sales or investment. Compute its new ROI.
e. Division B could reduce its investment so that its asset turnover increased by one time, while holding

14-46
123. Big Sky Industries is a division of a major corporation. The following data are for the latest year of
operations:
Sales $24,900,000
12%
return
Required:


14-47
operations:
Sales $12,700,000
16%
return
Required:


125. Raisin Corporation uses residual income to evaluate the performance of its divisions. The minimum
required rate of return for performance evaluation purposes is 19%. The Processed Foods Division had
average operating assets of $410,000 and net operating income of $86,000 in June.
Required:
What was the Processed Foods Division's residual income in June?

14-48
126. The Parts Division of the Stein Corporation had average operating assets of $150,000 and net operating
income of $27,800 in March. The company uses residual income to evaluate the performance of its
divisions, with a minimum required rate of return of 17%.
Required:
What was the Parts Division's residual income in March?

127. Edinger Industries is a division of a major corporation. The following data are for the latest year of
operations:
Sales $20,760,000
16%
return
Required:
What is the division's residual income?

14-49
128. The following information is available about the status and operations for Division A of Triplex Company,
Division A
Required:
a. Compute the residual income for Division A.

b. Division A could increase its profit by $4,000 by increasing its investment by $30,000. Compute its new
residual income.
13%), without increasing total sales or investment. Compute its new residual income.
total sales and profit constant. Compute its new residual income.

14-50
129. The following information is available about the status and operations for Division B of Tallon Company,
Division B
Required:
a. Compute the residual income for Division B.

b. Division B could increase its profit by $25,000 by increasing its investment by $100,000. Compute its
new residual income.

14-51
130. The Augment Manufacturing Company has three divisions: X Division, Y Division, and Z Division.
Operating results for the three divisions for last year were as follows:
Div X Div Y Div Z

Residual income $98,400 $27,200 $12,000
Net operating income 188,600 115,600 76,000
Average operating
820,000 680,000 400,000
assets
Sales 1,640,000 1,445,000 1,040,000
Required:
a. What is the ROI for each of the three divisions?

b. What is the cost of capital for each of the three divisions?

131. The Butyl Division of the Swiss Corporation just started operations. It purchased depreciable assets costing
$2,500,000 with an expected life of five years, after which the assets can be salvaged for $400,000.
Depreciation is computed for the financial statements on a straight-line basis, using the salvage value.
Annual cash operating flows are $1,300,000.
Required:
a. Compute the division's return on investment (ROI) for each year, using beginning of the year asset
values, historical costs, and net book values.
b. Compute the division's return on investment (ROI) for each year, using end of the year asset values,
historical costs, and net book values.

14-52
132. The Butyl Division of the Swiss Corporation just started operations. It purchased depreciable assets costing
$2,500,000 with an expected life of five years, after which the assets can be salvaged for $400,000.
Depreciation is computed for the financial statements on a straight-line basis, using the salvage value.
Annual cash operating flows are $1,300,000 for year 1. Assume that all cash flows and asset prices
increase by 12.5% per year.
Required:
a. Compute the division's ROI for the first three years, using end of the year asset values, current costs, and
net book values.
b. Compute the division's ROI for the first three years, using end of the year asset values, current costs, and
gross book values.

14-53
133. Three years ago, one division of the Calsone Enterprise Company purchased depreciable assets costing
$2,000,000. The cash flows from these assets for the past three years have been:
Year Cash Flows

1 $600,000
2 700,000
3 810,000
Calsone used the straight-line depreciation method; the estimated useful life is 10-years with no salvage
value. For return on investment (ROI) calculations, Calsone uses end-of-year balances.
Required:
a. What was the ROI for each year using historical cost and gross book value?
b. What was the ROI for each year using historical cost and net book value?

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

14-54
135. What are two disadvantages of using divisional income as a performance measure?

136. Describe the two main limitations of return on investment.

137. How does the use of residual income overcome the limitations of using return on investment?

138. How does EVA differ from residual income?

14-55
139. "I think that EVA is the best performance measure. I am going to recommend that we evaluate all
managers, of plants, divisions, subsidiaries, up to the chief executive officer (CEO), using it." Do you think
this statement is appropriate? Explain.

140. 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?

141. What is the problem with choosing a beginning, ending or average balance when measuring the investment
base for performance evaluation?

14-56
142. Financial data for Windsor, Inc. for last year appear below:
Windsor, Inc.
Statements of Financial Position
Beginning Ending

Balance Balance
Assets:
Cash $250,000 $260,000
Accounts receivable 120,000 135,000
Inventory 230,000 205,000
Plant and equipment (net) 420,000 380,000
Investment in Pine Company 220,000 250,000
Land (undeveloped) 430,000 430,000
Total assets $1,670,000 $1,660,000
Liabilities and stockholders'

equity:
Accounts payable $160,000 $140,000
Long-term debt 800,000 800,000
Stockholders’ equity 710,000 720,000
Total liabilities and
$1,670,000 $1,660,000
Stockholders’ equity
Windsor, Inc.
Income Statement
Sales $1,750,000
Less operating expenses 1,470,000
Net operating income 280,000
Less interest and taxes:
Interest expense $96,000
Tax expense 70,000 166,000
Net income $114,000
The company paid dividends of $104,000 last year. The "Investment in Pine Company" on the statement
of financial position represents an investment in the stock of another company.
Required:
a. Compute the company's margin, turnover, and return on investment for last year.
b. The Board of Directors of Windsor, Inc. has set a minimum required return of 25%. What was the
company's residual income last year?

14-57

14-58
143. Financial data for Beaker Company for last year appear below:
Beaker Company
Beginning Ending

Balance Balance
Assets:
Cash $50,000 $70,000
Inventory 30,000 35,000
Investment in Cedar Company 80,000 100,000
Total assets $470,000 $510,000
Liabilities and owners' equity:
Owners' equity 150,000 170,000
Total liabilities and owners' equity $470,000 $510,000
Beaker Company
Income Statement
Sales $414,000
Less operating expenses 351,900
Tax expense 10,000 40,000
Net income $22,100
The company paid dividends of $2,100 last year. The "Investment in Cedar Company" on the statement of
financial position represents an investment in the stock of another company.
Required:
b. The Board of Directors of Beaker Company has set a minimum required return of 20%. What was the

14-59

144. Xi, Inc. is just starting up. The management team has decided from the beginning that decentralization was
the preferred organizational style and has made this clear in all interviews and discussions with potential
employees. Mr. Yang, the CEO, is unsure about the best way to evaluate his division managers. He has
heard the terms return on investment, residual income, economic value added, and flexible budgets but
wants to know the pros and cons of each.
Required:
Briefly describe ROI, residual income, EVA and other approaches to performance evaluation. Include in
your discussion, where appropriate, how to calculate the measure and problem areas in the development of
some of the results.

145. Mrs. Young is the manager of the Children's Toy division of Ferguson Corporation. Every year she just
misses the cut off established by the company for the awarding of bonuses. She is concerned inasmuch as
she believes she is running her division effectively and her income has been increasing slowly but steadily
over the years she has been with the company.
She knows that the company uses ROI as the performance measure to evaluate divisions and begins to
study the formula to see what she should do to improve the ROI for her division.
Required:
Briefly discuss several ways to improve ROI.

14-60
146. Decentralization is lauded as important to good management. But it is not without its problems.
Required:
Identify the advantages and disadvantages of decentralization? How do ROI, Residual Income, and EVA
affect these issues?

14-61
147. Mallory, Inc. has the following data available for two of its divisions for last year:
Asian European

Division Division
Sales $460,000 $900,000
Contribution Margin 184,000 470,000
Operating income 92,000 90,000
Weighted average cost of
14% 14%
capital
The imputed interest for Mallory, Inc. is 24%.

The tax rate for Mallory, Inc. is 18%.
Required:
(1) Compute the following for each division:

(a) Sales margin.
(b) Capital turnover.
(c) ROI.
(d) Residual income.
(e) EVA (assume there are no current liabilities).
(2) Briefly discuss which division appears most successful and why?

14-62
148. Roxie, Inc. has used a decentralized form of organizational structure for the past five years. The controller,
Ms. Hamburg, has noticed that some of the divisions are still using fixed assets that are fully depreciated
and that there has been little acquisition activity in these divisions. Coupled with this are very high ROIs,
especially when compared to the other divisions that seem to have a regular program of disposition and
replacement of fixed assets.
She takes her concerns and observations to the Financial Vice President who says he will review her
findings and look into the problem.
Required:
1) What are the potential negative effects of decentralization?

2) Specifically discuss the issues involved in suboptimization.

14-63
149. Tran Company has the following financial statements for the year ended December 31, 2016.
Tran Company
Balance Sheet
For 2016
Cash $1,600,000
Accounts Receivable 3,000,000
Inventory 2,500,000
Current Assets $7,100,000
Long-Lived Assets 14,500,000
Total Assets $21,600,000
Current Liabilities $1,200,000
Long-Term Debt 2,400,000
Shareholder Equity 18,000,000
Total Debt and Equity $21,600,000
Tran Company
Income Statement
For Year Ended Dec. 31, 2016
Sales $20,000,000
Cost of Sales 15,000,000
Gross Margin $5,000,000
Operating Expenses 2,500,000
Operating Income $2,500,000
Taxes 1,000,000
Net Income $1,500,000
Tran Company
Cash Flows from Operations
Plus Depreciation Expense 1,000,000
+ Decrease (- Increase) in Acct. Rec. &
---
Inventory
+ Increase (- Decrease) in Current Liabilities ---
Cash Flows from Operations $2,500,000
Some additional information about 2016 includes:
Industry
Tran
Data
Year End Stock Price $23.00
Number of Shares Outstanding 1,800,000
Sales Multiplier 2.10
14-64
Free Cash Flow Multiplier 22.00
Earnings Multiplier 18.00
Accounts Receivable Turnover 6.60
Inventory Turnover 5.80
Current Ratio 2.20
Quick Ratio 1.50
Cash flows from Operations
1.50
Ratio
Free Cash Flow Ratio 1.00
Gross Margin Percentage 30%
Return on Assets (Net Book
18%
Value)
Return on Equity 22%
Training Expense $500,000
Income Tax Rate 40%
Depreciation Expense $1,000,000
Dividends ---
Required:
1. Complete a business analysis of Tran Company for 2016.

2. Complete a business valuation for Tran Company for 2016.

14-65
150. Suade Inc. manufactures furniture and is organized into three large divisions: bedroom, living room, and
dining room furniture. The following information presents operating revenues, operating incomes and
invested assets of the company over the last three years. (all figures in 000s)
Operating Revenues 2016 2017 2018

Dining Room $8,000 $15,000 $16,000
Living Room 4,500 3,600 2,400
Bedroom 8,800 7,600 6,600
Operating Income
Dining Room $2,500 $3,100 $1,800
Living Room 450 900 600
Bedroom 1,200 1,500 1,600
Invested Assets
Dining Room $12,000 $12,500 $12,500
Living Room 2,500 2,400 2,200
Bedroom 4,500 4,700 4,900
The following table shows the number of managers covered by the current compensation package of Suade
Inc.:
Number of Managers 2016 2017 2018

Dining Room 300 350 375
Bedroom 120 140 175
The current compensation package is an annual bonus award. The managers share in the bonus pool. The
pool is calculated as 12% of the annual residual income of the company. The residual income is defined as
operating income minus an interest charge of 15% of invested assets.
Required:
(1) Use investment turnover, return on sales, and ROI to explain the differences in profitability of the three
divisions.
(2) Compute the bonus amount to be paid during each year. Also, compute the (average) individual
executive bonus amounts.
(3) If the bonus were calculated by divisional residual income what would be the bonus amounts?
(4) Discuss the benefits and problems of basing the bonus on residual income of a company compared to
using divisional residual income.

14-66

14-67
151. The High Seas, Inc. manufactures water vessels and is organized into three large divisions: jet skis, fishing
boats, and yachts. The following information presents operating revenues, operating incomes, and invested
assets of the company over the last three years:
Operating Revenues
2016 2017 2018
(all figures in $000s)
Jet Skis $2,000 $3,000 $4,000
Fishing Boats 5,000 5,000 4,000
Yachts 8,000 7,000 8,000
Operating Income
Jet Skis $500 $700 $1,000
Fishing Boats 3,000 2,500 2,000
Yachts 4,000 3,000 3,500
Invested Assets
Jet Skis $1,200 $1,500 $2,000
Fishing Boats $2,000 $1,500 $1,500
Yachts 3,000 2,500 3,000
The following table shows the number of managers covered by the current compensation package of The
High Seas, Inc.:

Jet Skis 50 60 70
Fishing Boats 200 180 160
Yachts 250 200 250
The current compensation package is an annual bonus award. The managers share in the bonus pool. The
pool is calculated as 10% of the annual residual income of the company. The residual income is defined as
operating income minus an interest charge of 14% of invested assets.
Required:
(2) If the bonus was calculated by divisional residual income, what would be the bonus amounts?

14-68
Chapter 14 Business Unit Performance Measurement Answer Key
True / False Questions

1. Divisional income statements do not have to follow generally accepted accounting principles (GAAP)
because they are internal reports.

TRUE
GAAP is only required for external reports.

AACSB: Analytical Thinking
AICPA: FN Decision Making
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 14-01 Evaluate divisional accounting income as a performance measure.
Topic: Accounting Income

2. One advantage of using after-tax income as a performance measure of divisional results is that it is a
financial accounting measure that can also be used to compute organizational income.

TRUE
This makes it easier to understand and compare.

Blooms: Remember
Difficulty: 1 Easy

3. One disadvantage of using after-tax income as a performance measure of divisional results is that it is an
absolute measure which makes it difficult to compare divisions of significantly different sizes.

TRUE
Larger divisions will naturally show larger income than a smaller division would.

Blooms: Remember
14-69
Difficulty: 2 Medium

4. The profit margin ratio is computed by dividing after-tax operating income by sales.

TRUE
This is the definition of the profit margin ratio.

Blooms: Remember
Difficulty: 1 Easy

5. In general, it is better to have a higher return on investment (ROI) than a lower one.

TRUE
This implies that either income is higher or the assets are being used more efficiently.

Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 14-02 Interpret and use return on investment (ROI).
Topic: Return on Investment

6. One problem associated with using accounting measures to evaluate divisional performance is the
measures are based on historical information.

TRUE
Historical costs may not reflect current conditions.

Blooms: Remember
Difficulty: 1 Easy

14-70
7. A problem with ratio-based measures is that managers can make decisions that improve divisional
income but lower total organizational income.

TRUE
This is the problem of suboptimization.

Blooms: Remember

8. It is not possible for a manager to accept an unacceptable project when his/her performance is evaluated
using ROI.

FALSE
Since ROI is a ratio, a division with a lower than average ROI may choose a project that does not meet
the corporate benchmarks.

Blooms: Remember
Difficulty: 1 Easy

9. Residual income is the difference between the divisional income and the cost of invested capital
required to operate the division.

TRUE
This is the definition of residual income.

Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 14-03 Interpret and use residual income (RI).
Topic: Residual Income Measures

14-71
10. The use of residual income reduces, but does not eliminate, the suboptimization problem.

TRUE
Suboptimization may still exist since accounting income does not necessarily reflect economic
performance.

Blooms: Remember

11. Managerial myopia is the distortion in incentives that result from using accounting measures to evaluate
performance.

TRUE
This is one definition of managerial myopia.

Blooms: Remember
Difficulty: 1 Easy

12. Most organizations use residual income instead of return on investment (ROI) as a performance
measure.

FALSE
ROI is much more common than residual income.

Blooms: Remember
Difficulty: 1 Easy

14-72
13. Economic value added (EVA) adjustments are made to both the after-tax income and the capital
employed.

TRUE
Both income and capital are adjusted to eliminate accounting distortions.

Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 14-04 Interpret and use economic value added (EVA).
Topic: Economic Value Added (EVA)

14. Treating research and development costs as an expense rather than a long-term asset may reduce a
manager's inclination to participate in research and development activities.

TRUE
There would be a large impact on income in a single year rather than spreading it over many years.

Blooms: Remember

15. One problem with economic value added (EVA) adjustments is determining the appropriate life for
expenditures that benefit multiple periods.

TRUE
There is uncertainty in how many years an expenditure will yield benefits.

Blooms: Remember
Difficulty: 1 Easy

14-73
16. Like return on investment (ROI), economic value added (EVA) adjustments fail to sufficiently address
the sub-optimization problem.

TRUE
Both ROI and EVA are ratio-based measures, which gives rise to suboptimization.

Blooms: Remember
Difficulty: 1 Easy

17. In general, a division's investment base includes an allocated share of the corporate headquarters'
assets.

FALSE
The goal is controllable investment, so corporate costs should not be allocated.

Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 14-05 Explain how historical cost and net book value-based accounting measures can be misleading in evaluating
performance.
Topic: Measuring the Investment Base

18. Using net book values instead of gross book values to compute return on investment (ROI) might
encourage an investment center manager to delay replacing inefficient assets until they are fully
depreciated.

TRUE
Book value decreases as the asset ages. Replacing an asset replaces a lower net investment with a larger
one.

Blooms: Remember
performance.

14-74
19. Current costs should not be used to compute either return on investment (ROI) or residual income
because current costs are not generally accepted accounting principles (GAAP).

FALSE
GAAP is not a relevant concern for either ROI or residual income.

Blooms: Remember
Difficulty: 1 Easy
performance.

20. Historical costs are based on the original costs to acquire a long-term asset, while current costs represent
the costs to replace the long-term asset.

TRUE
These are the definitions of historical and current cost.

Blooms: Remember
Difficulty: 1 Easy
performance.

Multiple Choice Questions

14-75
21. Which of the following is not an advantage of after-tax income as a performance measure?

A. It reflects the results of decisions under the division manager's control.
B. It summarizes the results of decisions affecting revenues and costs.
C. It makes comparison of divisions easy because they use the same measure, dollars of income.
D. Financial accounting income at the divisional level is computed differently from that of the income
for the firm.
After-tax income as a performance measure is easy to understand because it is financial accounting

income computed in the same way that income for the firm is computed.

Blooms: Remember
Difficulty: 1 Easy
Topic: Divisional Performance Measurement

22. Which of the following statements is(are) true?
(A) Divisional income statements do not include allocated common costs.

(B) The gross margin ratio is computed by dividing operating income by sales.

A. Only A is true.

B. Only B is true.
C. Both A and B are true.
D. Neither A nor B is true.
Divisional statements do include allocations, the gross margin ratio is gross margin divided by sales.

Blooms: Remember
Difficulty: 1 Easy
Topic: Divisional Performance Measurement

14-76
23. After-tax income divided by sales is called the:


This is the formula for the profit margin ratio.

Blooms: Remember
Difficulty: 1 Easy

24. The measure (ratio) that reflects the performance of a manager regarding sales and cost of goods sold,
but not other operating costs and income taxes, is called the:


Gross margin = sales - cost of goods sold.

Blooms: Remember
Difficulty: 1 Easy

25. If a division is evaluated using return on investment (ROI) without regard to how assets are financed,
the denominator in the ROI calculation will be:

A. current assets.

B. working capital.
C. total assets available.
D. total assets employed.
Total assets employed takes out the financing.

14-77
Blooms: Remember
Difficulty: 1 Easy

26. Return on investment (ROI) can be decomposed into the asset turnover and the:


Asset turnover × profit margin ratio = ROI

Blooms: Remember
Difficulty: 1 Easy

27. The asset turnover is a measure (ratio) of an investment center's ability to:

A. earn profits.

B. generate sales.
C. control costs.
D. remain solvent.
Asset turnover = Sales/divisional assets

Blooms: Remember
Difficulty: 1 Easy

14-78
28. Which of the following statements does not represent a limitation of using return on investment (ROI)
for measuring and evaluating performance?

A. ROI uses accounting income which is based on historical costs.

B. ROI cannot be used to compare divisions of different sizes.
C. ROI has the potential to create goal congruence problems.
D. ROI fails to align some costs incurred in one period with the benefits received in another period.
ROI can be used to compare different sized divisions—this is an advantage of ROI.

Blooms: Remember
Difficulty: 1 Easy

29. How will increases in the following items affect return on investment (ROI)?

Expenses Inventory

A. Option A
B. Option B
C. Option C
D. Option D
Increasing expenses decreases income (the numerator) and will decrease ROI. An increase in inventory
will increase assets (the denominator) which will decrease ROI.

Blooms: Apply

14-79
30. A manager can always increase his/her return on investment (ROI) by:

A. reducing the asset turnover.

B. decreasing residual income.
C. increasing the operating profit margin.
D. expanding operating assets while holding sales and expenses constant.
Increasing the operating profit margin is accomplished by increasing the numerator (income) which
would increase ROI, or decreasing the denominator (sales) which would also increase asset turnover
which will yield an increased ROI.

Blooms: Apply

31. The Maxim Corporation reported the following operating results for its three divisions: South, West,
and East.
South West East

Sales $380,000 $1,700,000 $2,000,000
Operating
$20,000 $50,000 $100,000
profits
Divisional
$200,000 $625,000 $800,000
assets
Which division has the smallest return on investment (ROI)?

A. South.
B. West.
C. East.
See calculations below.
South: $20,000/200,000 = 10.0%

West: $50,000/625,000 = 8.0%
East: $100,000/800,000 = 12.5%

Blooms: Apply
14-80
Difficulty: 1 Easy

and East.
South West East

Sales $380,000 $1,700,000 $2,000,000
Operating
$20,000 $50,000 $100,000
profits
Divisional
$200,000 $625,000 $800,000
assets
Which division has the largest asset turnover?

A. South.
B. West.
C. East.
South: $380,000/200,000 = 1.90

West: $1,700,000/625,000 = 2.72
East: $2,000,000/800,000 = 2.50

Blooms: Apply
Difficulty: 1 Easy

14-81
and East.
South West East

Sales $380,000 $1,700,000 $2,000,000
Operating
$20,000 $50,000 $100,000
profits
Divisional
$200,000 $625,000 $800,000
assets
Which division's profit margin is the highest?

A. South.
B. West.
C. East.
South: $20,000/380,000 = 5.26%

West: $50,000/1,700,000 = 2.94%
East: $100,000/2,000,000 = 5.00%

Blooms: Apply
Difficulty: 1 Easy

14-82
34. The following information was presented by User-Friendly Industries Company for an asset purchased
at the end of the previous year.

Annual operating profit, including
$4,000
depreciation
Salvage value $-0-
What is the return on investment (ROI) assuming User-Friendly (a) uses the straight-line method for

A. 11.1%.
B. 20.0%.
C. 22.2%.
D. 25.0%.
Previous year depreciation: ($20,000 - 0)/10 = $2,000

$4,000/($20,000 - 2,000) = 22.2%

Blooms: Apply

14-83
35. The following information was presented by Outdoors Manufacturing Company for an asset purchased
at the end of the previous year.

Salvage value $-0-
What is the return on investment (ROI) assuming Outdoors (a) uses the straight-line method for

A. 11.1%.
B. 20.0%.
C. 10.0%.
D. 22.2%.

($4,000 - 2,000)/($20,000 - 2,000) = 11.1%

Blooms: Apply

14-84
36. The following information was presented by Shower Wonder Enterprises for an asset purchased at the
beginning of the previous year.

Salvage value $-0-
What is the return on investment (ROI) assuming Shower Wonder (a) uses the straight-line method for
depreciation and (b) average net book values to compute ROI?

A. 21.1%.
B. 20.0%.
C. 22.2%.
D. 11.76%.

Average "net" book value this year = ($18,000 + 16,000)/2 = $17,000
($4,000 - $2,000)/$17,000 = 11.76%

Blooms: Apply
Difficulty: 3 Hard

37. Garage Corporation's return on investment (ROI) on some new equipment was 20% using beginning-of-
year net book value. The gross book value of the equipment is $250,000. Accumulated depreciation at
the beginning of the year was $10,000. This represents one-half year's straight-line depreciation. What
is the annual before-tax cash flow from the new equipment?

A. $68,000.
B. $60,000.
C. $48,000.
D. $20,000.
(Operating income - $20,000)/($250,000 - 10,000) = .20; Operating income = $68,000

Blooms: Analyze
14-85

38. Madrigal Corporation purchased a new machine for $120,000. The machine has an estimated useful life
of 10-years with no salvage value and a return on investment (ROI) of 15%. ROI is computed using
annual cash flows and straight-line depreciation. What is the annual cash flow using the gross book
value method?

A. $12,200.
B. $18,000.
C. $28,200.
D. $30,000.
(Operating income - $12,000)/($120,000) = .15; Operating income = $30,000

Blooms: Analyze

39. The Nacho Division of the Tex-Mex Company has a return on investment (ROI) of 12%, sales of
$200,000, and an asset turnover of 2.0. What was Nacho's operating income?

A. $6,000.
B. $12,000.
C. $24,000.
D. $48,000.
Assets = $200,000/2.0; operating income = .12($100,000) = $12,000

Blooms: Analyze

14-86
40. The following information is available for Sweet Dreams Company:
Sales $100,000
Cost of capital 10%
What is Sweet Dreams Company's return on investment (ROI)?

A. 6.0%.
B. 10.0%.
C. 15.0%.
D. 24.0%.
ROI = $6,000/40,000 = 15.0%

Blooms: Apply
Difficulty: 1 Easy

41. The Gallop Company has an asset turnover of 3.0 times, using assets of $45,000. The company also has
a return on investment (ROI) of 20%. What was Gallop's operating profit margin?

A. 5.0%.
B. 6.0%.
C. 6.7%.
D. 8.3%.
Sales = $45,000 × 3.0; sales = $135,000; Operating income = $45,000 × .20 = $9,000; Operating profit
margin = $9,000/135,000 = 6.7%

Blooms: Apply

14-87
42. How will decreases in the following items affect return on investment (ROI)?
Sales Equipment

A. Option A
B. Option B
C. Option C
D. Option D
Decreasing sales decreases income (the numerator) which will decrease ROI. Decreasing equipment
will decrease assets (the denominator) which will increase ROI.

Blooms: Apply

43. A firm earning a profit can increase its return on investment by: (CMA adapted)

A. increasing sales revenue and operating expenses by the same dollar amount.
B. decreasing sales revenues and operating expenses by the same percentage.
C. increasing investment and operating expenses by the same dollar amount.
D. increasing sales revenues and operating expenses by the same percentage.
Changing factors by the same dollar amount will yield zero change. Increasing revenues and expenses
by the same percentage will increase profits by that percentage.

Blooms: Apply

14-88
44. Return on investment (ROI) is a very popular measure employed to evaluate the performance of
corporate segments because it incorporates all of the major ingredients of profitability (revenue, cost,
investment) into a single measure. Under which one of the following combinations of actions regarding
a segment's revenues, costs, and investment would a segment's ROI always increase? (CIA adapted)
Sales Equipment Investment

A. Increase Decrease Increase
B. Decrease Decrease Decrease
C. Increase Increase Increase
D. Increase Decrease Decrease

A. Option A
B. Option B
C. Option C
D. Option D
The key word is "always" increase. To guarantee this, both the numerator would have to increase and
the denominator decrease. Decreasing revenues and costs both may lead to an increase in ROI, but only
if the decrease in costs is larger than the decrease in revenues. Increasing revenue and decreasing costs
guarantees the numerator increases.

Blooms: Apply

14-89
45. The following information pertains to Artemis Co. for the year ended December 31: (CPA adapted)
Sales $600,000
Income $100,000
Capital investment $400,000
Which of the following equations should be used to compute Artemis' return on investment (ROI)?

A. (4/6) × (6/1) = ROI

B. (6/4) × (1/6) = ROI
C. (4/6) × (1/6) = ROI
D. (6/4) × (6/1) = ROI
ROI = $100,000/600,000 × $600,000/400,000 = 1/6 × 6/4

Blooms: Apply

46. The following information pertains to Zootime Co.'s Shelter Division for the current year: (CPA
adapted)
Sales $311,000
Variable cost $250,000
Traceable fixed costs $50,000
Average invested capital $40,000
Imputed interest rate 10%
Zootime's return on investment was:

A. 10.00%.
B. 13.33%.
C. 27.50%.
D. 30.00%.
($311,000 - 250,000 - 50,000)/40,000 = 27.5%

Blooms: Apply
14-90

47. A division earning a profit will increase its return on investment (ROI) if it increases operating expenses
and:

A. sales by the same dollar amount.

B. sales by the same percentage.
C. investment by the same dollar amount.
D. investment by the same percentage.
Increasing investment (along with increasing expenses) will decrease ROI. Increasing expenses and
sales by the same dollar amount will not change the numerator, so ROI is unchanged. Increasing
expenses and sales by the same percentage will increase profit and thus ROI.

Blooms: Apply
Difficulty: 3 Hard

48. In computing the margin in a ROI analysis, which of the following is used?

A. Sales in the denominator.

B. Net operating income in the denominator.
C. Average operating assets in the denominator.
D. Residual income in the denominator.
The formula for margin is Net profit divided by Net sales.

AACSB: Reflective Thinking
AICPA: FN Measurement
Blooms: Remember

14-91
49. In determining the dollar amount to use for operating assets in the return on investment (ROI)
calculation, companies will generally use either net book value or gross cost of the assets. Which of the
following is an argument for the use of net book value rather than gross cost?

A. It is consistent with how assets are reported on the balance sheet.
B. It eliminates the depreciation method as a factor in ROI calculations.
C. It encourages the replacement of old, worn-out equipment.
D. all of the above.
All of these items are arguments for the use of net book value.

Blooms: Remember

50. Average operating assets are $110,000 and net operating income is $23,100. The company invests
$25,000 in new assets for a project that will increase net operating income by $4,750. What is the return
on investment (ROI) of the new project?

A. 21%.
B. 19%.
C. 18.5%.
D. 20%.
ROI = Net operating income ÷ Average operating assets

= $4,750 ÷ $25,000 = 19%

Blooms: Apply

14-92
51. Last year a company had stockholders' equity of $160,000, net operating income of $16,000, and sales
of $100,000. The turnover was 0.5. The return on investment (ROI) was:

A. 10%.
B. 9%.
C. 8%.
D. 7%.
Margin = Net operating income ÷ Sales

16% = $16,000 ÷ $100,000
ROI = Margin × Turnover

8% = 16% × .5

Blooms: Apply

14-93
52. Sales and average operating assets for Wyeth Company and Genesis Company are given below:
Average Operating
Sales
Assets
Wyeth Company $20,000 $8,000
Genesis Company $50,000 $10,000
What is the margin that each company will have to earn in order to generate a return on investment of
20%?

A. 12% and 16%.

B. 50% and 100%.
C. 8% and 4%.
D. 2.5% and 5%.
Turnover = Sales ÷ Average operating assets

= $20,000 ÷ $8,000 = 2.5
ROI ÷ Turnover = Margin

= 20% ÷ 2.5 = 8%
Turnover = Sales ÷ Average operating assets

= $50,000 ÷ $10,000 = 5

= 20% ÷ 5 = 4%

Blooms: Apply
Difficulty: 3 Hard

14-94
53. Rex Company's sales last year totaled $150,000 and its return on investment (ROI) was 12%. If the
company's turnover was 3, then its net operating income for the year must have been:

A. $6,000.
B. $2,000.
C. $18,000.
D. it is impossible to determine from the data given.

= 12% ÷ 3 = 4%
Margin × Sales = Net operating income
4% × $150,000 = $6,000

Blooms: Apply
Difficulty: 3 Hard

14-95
Year 1 Year 2
Margin 16% ?
Turnover 2.5 2
Sales ? ?
The margin in Year 2 was:

A. 48%.
B. 32%.
C. 20%.
D. 10%.
ROI = Margin × Turnover

= 16% × 2.5 = 40%

= 40% ÷ 2.0 = 20%

Blooms: Apply
Difficulty: 3 Hard

14-96
Year 1 Year 2
Margin 16% ?
Turnover 2.5 2
Sales ? ?
Sales in Year 2 amounted to:

A. $250,000.
B. $300,000.
C. $325,000.
D. $350,000.
Net operating income = ROI × Average operating assets = 40% × $150,000 = $60,000
Sales = Net operating income ÷ Margin

= $60,000 ÷ 20% = $300,000

Blooms: Apply

14-97
Year 1 Year 2
Margin 16% ?
Turnover 2.5 2
Sales ? ?
Average operating assets in Year 1 were:

A. $160,000.
B. $150,000.
C. $125,000.
D. $100,000.
Sales = Net operating income ÷ Margin

= $40,000 ÷ 16% = $250,000
Average operating assets = Sales ÷ Turnover

= $250,000 ÷ 2.5 = $100,000

Blooms: Apply
Difficulty: 3 Hard

14-98
Year 1 Year 2
Margin 16% ?
Turnover 2.5 2
Sales ? ?
Net operating income in Year 2 amounted to:

A. $60,000.
B. $50,000.
C. $40,000.
D. $35,000.
ROI = 16% × 2.5 (Year 1 & Year 2)

ROI = 40% (Year 1 & Year 2)
ROI = Margin × 2 (Year 2)
40% = 20% × 2 (Year 2)
Turnover = Sales ÷ Average operating assets (Year 2)
2 = Sales ÷ $150,000 (Year 2)
Sales = $300,000 (Year 2)
Net operating income = Sales × Margin
= $300,000 × 20% = $60,000

Blooms: Apply
Difficulty: 3 Hard

14-99
58. The following data are available for the South Division of Manhattan Products, Inc. and the single
product it makes:
Unit selling price $20

Variable cost per unit $12
Annual fixed costs $280,000
How many units must South sell each year to have an ROI of 16%?

A. 240,000.
B. 1,300,000.
C. 52,000.
D. 65,000.
Net operating income = ROI × Average operating assets

= 16% × $1,500,000 = $240,000
(Fixed costs + Target profit) ÷ Contribution margin per unit

= ($280,000 + $240,000) ÷ ($20 - $12)
= $520,000 ÷ $8
= 65,000 units

Blooms: Apply
Difficulty: 3 Hard

14-100
59. The Country Garden Company's current net operating income is $16,800 and its average operating
assets are $80,000. The Country Garden's required rate of return is 18%. A new project being
considered would require an investment of $15,000 and would generate annual net operating income of
$3,000. What is the residual income of the new project?

A. 20.8%.
B. 20%.
C. $(150).
D. $300.
Net operating income $3,000

Minimum required return ($15,000 × 18%) 2,700
Residual income $300

Blooms: Apply
Difficulty: 1 Easy

60. Imagination Corporation uses residual income to evaluate the performance of its divisions.
Imagination's minimum required rate of return is 11%. In April, the Commercial Products Division had
average operating assets of $100,000 and net operating income of $9,400. What was the Commercial
Products Division's residual income in April?

A. $(1,600).
B. $1,600.
C. $1,034.
D. $(1,034).

Minimum required return ($100,000 ×
11,000
11%)
Residual income ($1,600)

14-101
Blooms: Apply
Difficulty: 1 Easy

61. Division B had an ROI last year of 15%. The division's minimum required rate of return is 10%. If the
division's average operating assets last year were $450,000, then the division's residual income for last
year was:

A. $67,500.
B. $22,500.
C. $37,500.
D. $45,000.
Minimum required return ($450,000 × 10%) $45,000

Net operating income ($450,000 × 15%) $67,500
Residual income $22,500

Blooms: Apply
Difficulty: 3 Hard

62. Which of the following will not result in an increase in the residual income, assuming other factors
remain constant?

A. An increase in sales.

B. An increase in the minimum required rate of return.
C. A decrease in expenses.
D. A decrease in operating assets.
An increase in the minimum required rate of return has nothing to do with the residual income formula.

Blooms: Remember

14-102
63. All other things the same, which of the following would increase residual income?

A. Increase in average operating assets.

B. Decrease in average operating assets.
C. Increase in minimum required return.
D. Decrease in net operating income.
A decrease in average operating assets is a factor that would increase residual income, while the other
options would decrease residual income.

Blooms: Remember

64. Which of the following statement(s) is/are true?
(A) If a division's return on investment (ROI) exceeds its cost of capital, then its residual income is
positive.
(B) If a division's cost of capital equals its return on investment (ROI), then its residual income is zero.

Both of the statements are true.

Blooms: Remember

14-103
65. Residual income is similar to the _________ notion of profit as being the amount left over after all
costs, including the cost of the capital employed in the division, are subtracted.

A. accountant's
B. manager's
C. shareholder's
D. economist's
Economists consider profits to include a charge for the cost of capital.

Blooms: Remember
Difficulty: 1 Easy

66. Which of the following statement(s) is/are false?
(A) Residual income can be used to compare divisions of different sizes.

(B) Residual income can be used to compare divisions that are profit centers.

A. Only (A) is false.

B. Only (B) is false.
C. Both (A) and (B) are false.
D. Neither (A) and (B) is false.
Residual income cannot be used for different sizes; residual income is used for investment centers—
profit centers have no control over the investment and are evaluated based on profit.

Blooms: Remember

14-104
67. Managerial performance can be measured in many different ways including return on investment (ROI)
and residual income. A good reason for using residual income instead of ROI is that:

A. residual income can be computed without regard to identifying an investment base.
B. appropriate goal congruence behavior is more likely to occur when using residual income.
C. residual income is well accepted in many organizations and often used in the financial press.
D. ROI does not take into consideration both the investment turnover ratio and return-on-sales
percentage.
Residual income increases the likelihood of goal congruence since the target return (cost of capital) is
set by top management.

Blooms: Apply

68. How will decreases in the following items affect residual income?

Expenses Inventory

A. Option A
B. Option B
C. Option C
D. Option D
Decreasing expenses increases income and will increase residual income. A decrease in inventory will
decrease assets which will increase residual income.

Blooms: Apply

14-105
69. 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)

A. residual income is a measure over time, while ROI represents the results for one period.
B. residual income concentrates on maximizing absolute dollars of income rather than a percentage
return, as with ROI.
C. the imputed interest rate used in calculating residual income is more easily derived than the target
rate that is compared to the calculated ROI.
D. average investment is employed with residual income while year-end investment is employed with
ROI.
The suboptimization problem with using a ratio measure is avoided.

Blooms: Apply


B. desirable investment decisions will not be neglected by high-return divisions.
D. the arguments about the implicit cost of interest are eliminated.
Problems in measuring the asset base, gross versus net book values, and implicit cost of interest are
present in both residual income and ROI. Residual income avoids the suboptimization problem with
high return divisions.

Blooms: Apply

14-106
71. Kevin Thomas is the general manager of the Modular Homes Division, and his performance is
measured using the residual income method. Thomas is reviewing the following forecasted information
for his division for next year: (CMA adapted)
Amount
Category (thousands)
Working capital $1,800
Revenue 30,000
Plant and equipment 17,200
If the cost of capital is 15% and Thomas 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.
($30,000,000 - costs) - .15($1,800,000 + 17,200,000) = $2,000,000; Costs = $25,150,000

Blooms: Analyze

14-107
72. Bella Vista Service Co. is a computer service center. For the month of May, Bella Vista Service Co. had
the following operating statistics: (CMA adapted)
Sales $450,000
Operating income 25,000
Net profit after taxes 8,000
Total assets 500,000
Stockholder’s equity 200,000
Cost of capital 6%
Based on the above information, which one of the following statements is correct?

A. Bella Vista Service Co. has a return on investment of 4%.

B. Bella Vista Service Co. has a residual income of $(2,000).
C. Bella Vista Service Co. has a return on investment of 5.6%.
D. Bella Vista Service Co. has a residual income of $(22,000).
ROI = $8,000/500,000 = 1.6%; Residual income = $8,000 - .06($500,000) = $(22,000)

Blooms: Analyze

73. How will increases in the following items affect residual income?
Sales Equipment

A. Option A
B. Option B
C. Option C
D. Option D
An increase in sales increases income which increases residual income. An increase in equipment
increases assets which will decrease residual income.

14-108
Blooms: Apply

74. Which of the following should not be used for the cost of capital to compute residual income?

A. Historical weighted average cost of capital.

B. Marginal after-tax cost of new equity capital.
C. Cost of debt and equity used to finance a project.
D. Return on investment (ROI).
Return on investment should not be used because it is not a measure of the cost of capital—it is a
measure of performance.

Blooms: Apply

75. Which one of the following items would most likely not be incorporated into the calculation of a
division's investment base when using the residual income approach for performance measurement and
evaluation?

A. Land being held by the division as a potential site for a new plant and parking lot.
B. Division inventories when division management exercises control over the inventory levels.
C. Division accounts payable when division management exercises control over the amount of short-
term credit utilized.
D. Division accounts receivable when division management exercises control over credit policy and
credit terms.
Land is a strategic asset which is not controlled by the divisional manager.

Blooms: Remember
Difficulty: 1 Easy

14-109
76. The Pathways Company has an asset turnover of 3.0 times, using assets of $45,000. The company also
has a return on investment (ROI) of 20%. If the residual income was $2,250, what was the company's
cost of capital?

A. 6.0%.
B. 10.0%.
C. 15.0%.
D. 20.0%.
$2,250 = $9,000 - (cost of capital × $45,000); Cost of capital = 15.0%

Blooms: Analyze

77. In 2016, Evans Corporation had an operating profit of $750,000 and a residual income of $300,000. If
Evans' cost of capital is 15%, what is the amount of the invested capital?

A. $5,000,000.
B. $3,000,000.
C. $2,000,000.
D. $1,250,000.
$300,000 = $750,000 - (.15 × invested capital) = $300,000. Invested capital = $3,000,000

Blooms: Analyze

14-110
78. The following information is available for Kiss Company:
Sales $100,000
Cost of capital 10%
What is Kiss Company's residual income?

A. $2,000.
B. $2,500.
C. $3,500.
D. $4,000.
Residual income = ($100,000 - 94,000) - (.10 × $40,000) = $2,000

Blooms: Apply
Difficulty: 1 Easy

79. The following information has been gathered for the Door Division:
Return on investment (ROI) 15.0%

Sales $120,000
Profit margin 7.5%
Compute the Door Division's residual income.

A. $1,800.
B. $2,700.
C. $3,600.
D. $5,400.
Operating income = .075 × $120,000 = $9,000; Residual income = $9,000 - (.12 × $60,000) = $1,800

Blooms: Apply
14-111

80. Use the following information to compute residual income:
Sales $320,000
Operating income $60,000
Average current assets $250,000
Cost of capital 12%

A. $12,000.
B. $22,500.
C. $30,000.
D. $48,000.
Need to calculate total assets using ROI: Assets = $60,000/.15 = $400,000; Residual income = $60,000 -
(.12 × $400,000) = $12,000

Blooms: Apply
Difficulty: 3 Hard

14-112
A B C
Sales $320,000 $540,000 ?
Average Division
250,000 320,000 80,000
Assets
What was A Division's residual income last year?

A. $12,000.
B. $22,500.
C. $30,000.
D. $48,000.
Assets = $60,000/.15 = $400,000; Residual income = $60,000 - (.12 × $400,000) = $12,000

Blooms: Apply
Difficulty: 3 Hard

14-113

A B C
Sales $320,000 $540,000 ?
Average Division
250,000 320,000 80,000
Assets
What was B Division's return on investment (ROI) last year?

A. 16.00%.
B. 20.00%.
C. 24.00%.
D. 33.75%.
Assets = $540,000/4 = $135,000; Profit = $540,000 × .05 = $27,000; ROI = ($27,000/$135,000) =

20.00%

Blooms: Apply
Difficulty: 3 Hard

14-114
A B C
Sales $320,000 $540,000 ?
Average Division
250,000 320,000 80,000
Assets
What was C Division's cost of capital last year?

A. 8%.
B. 12%.
C. 18%.
D. 20%.
$24,000 - × = $14,400; × = $9,600; CC × $80,000 = $9,600; CC = 12.0%

Blooms: Analyze
Difficulty: 3 Hard

return on investment (ROI) because: (CMA adapted)

B. desirable investment decisions will not be neglected by high return divisions.
Problems in measuring the asset base, gross versus net book values, and cost of capital are present in
both residual income and ROI. Residual income avoids the suboptimization problem with high return
divisions.

Blooms: Apply
14-115

85. Which one of the following items would most likely not be incorporated into the calculation of a
division's investment base when using the residual income approach for performance measurement and
evaluation? (CMA adapted)

A. Fixed assets employed in division operations.

B. Land being held by the division as a site for a new plant.
C. Division inventories when division management exercises control over the amount of short-term
credit used.
D. Division accounts payable when division management exercises control over the amount of short-
term credit used.
Land would be a strategic asset that is not controlled by the division manager.

Blooms: Apply


B. desirable investment decisions will not be rejected by divisions that already have a high ROI.
Residual income indicates those situations with more than a threshold return that should be accepted.

Blooms: Remember

14-116
87. Which of the following items would not be an example of an economic value added (EVA) adjustment
to eliminate accounting distortions?


C. Patent amortization.
D. Common stock.
Stock does not distort the accounting. R&D, advertising, and patents all need to be capitalized under
EVA.

Blooms: Remember
Difficulty: 1 Easy

88. Which of the following items would not require an adjustment to capital employed when using
economic value added (EVA)?


C. Preferred stock.
D. Patents developed.
Stock does not require an adjustment to capital employed; the other three do because they are expensed
under GAAP.

Blooms: Remember
Difficulty: 1 Easy

14-117
89. Economic value added (EVA) is a concept that is closely related to residual income. EVA is computed
by:

A. subtracting the adjusted total cost of capital from the adjusted after-tax income.
B. subtracting adjusted after-tax income from total divisional investment.
C. dividing adjusted after-tax income by adjusted divisional investment.
D. dividing adjusted after-tax income by adjusted total cost of capital.
EVA = adjusted income - (weighted average cost of capital × adjusted capital employed)

Blooms: Remember

90. Economic value added (EVA) assumes that which of the following GAAP expenses would not result in
an adjustment to either the income or the capital employed?


B. Use of process costing rather than job costing.
C. Advertising expenses.
D. Writeoff of goodwill.
Process versus job costing does not cause a distortion in computing economic performance.

Blooms: Remember

14-118
91. Which of the following statements regarding the use of historical costs and current costs to compute
return on investment (ROI) is(are) true?
(A) Historical costs are based on the original costs to acquire a long-term asset, while current costs
represent the costs to replace the long-term asset.
(B) For a specific multiple-period project, the return on investment (ROI) computed using current costs
will generally be less than the ROI computed using historical costs.


Both statements are true. (A) is the definition. (B) Current costs are almost always greater than
historical costs which will yield lower ROI.

Blooms: Remember
performance.

92. Level return on investments (ROI) over the life of a long-term project is more likely when ROI is
computed using:

A. historical costs and net book values.

B. historical costs and gross book values.
C. current costs and net book values.
D. current costs and gross book values.
Under historical costs, ROI decreases because prices are rising. Net book values cause ROI to increase.
Current costs and gross book value is most likely.

Blooms: Remember
performance.

14-119
93. Using ending balances for the investment base in computing return on investment (ROI) might

Acquiring early in the year and disposing before year end would result in profits being generated, but
the asset never appears in the asset base since it is disposed of before year-end. You have use of the
asset for the longest period of time.

Blooms: Remember
Difficulty: 3 Hard
performance.

94. Using beginning balances for the investment base in computing return on investment (ROI) might

Acquiring early in the year and disposing before year end would result in profits being generated, but
the asset never appears in the asset base since it is acquired after the base is measured. You have use of
the asset for the longest period of time.

Blooms: Remember
performance.

14-120
Year Cash flows

1 $1,200,000
2 $1,400,000
3 $1,620,000
The current (i.e., replacement) costs of these assets were expected to increase 25% each year. Marvin
used the straight-line depreciation method; the estimated useful life is 10-years with no salvage value.
For return on investment (ROI) calculations, Marvin uses end-of-year balances.
What is the ROI using historical cost and gross book value?

A. 20.0% 25.0% 30.5%
B. 25.0% 28.0% 32.0%
C. 18.0% 26.5% 28.0%
D. 30.0% 35.0% 40.5%

A. Option A
B. Option B
C. Option C
D. Option D
Year 1: ($1,200,000 - 400,000)/$4,000,000 = 20.0%

Year 2: ($1,400,000 - 400,000)/$4,000,000 = 25.0%
Year 3: ($1,620,000 - 400,000)/$4,000,000 = 30.5%

Blooms: Apply
performance.

14-121
Year Cash flows

1 $1,200,000
2 $1,400,000
3 $1,620,000
What is the ROI using historical cost and net book value?

A. 21.5% 34.0% 42.0%
B. 22.2% 31.3% 43.6%
C. 23.0% 32.0% 47.0%
D. 24.8% 35.0% 49.5%

A. Option A
B. Option B
C. Option C
D. Option D
Year 1: ($1,200,000 - 400,000)/($4,000,000 - 400,000) = 22.2%

Year 2: ($1,400,000 - 400,000)/($4,000,000 - 800,000) = 31.3%
Year 3: ($1,620,000 - 400,000)/($4,000,000 - 1,200,000) = 43.6%

Blooms: Apply
performance.

14-122
Year Cash flows

1 $1,200,000
2 $1,400,000
3 $1,620,000
What is the ROI using current costs and gross book value?

A. 14.0% 18.0% 22.4%
B. 13.0% 14.0% 14.0%
C. 12.0% 10.1% 9.5%
D. 14.0% 12.4% 10.7%

A. Option A
B. Option B
C. Option C
D. Option D
Year 1: [$1,200,000 - (400,000 × 1.25)]/[($4,000,000 × 1.25)] = 14.0%

Year 2: [$1,400,000 - (400,000 × 1.25 × 1.25)]/[($4,000,000 × 1.25 × 1.25)] = 12.4%
Year 3: [$1,620,000 - (400,000 × 1.25 × 1.25 × 1.25)]/[($4,000,000 × 1.25 × 1.25 × 1.25)] = 10.7%

Blooms: Apply
Difficulty: 3 Hard
performance.

14-123
Year Cash flows

1 $1,200,000
2 $1,400,000
3 $1,620,000
What is the ROI using current costs and net book value?

A. 14.6% 15.9% 16.0%
B. 15.8% 15.9% 14.9%
C. 15.6% 15.5% 15.3%
D. 15.6% 15.8% 11.9%

A. Option A
B. Option B
C. Option C
D. Option D
Year 1: [$1,200,000 - (400,000)(1.25)]/[($4,000,000 - 400,000)(1.25)] = 15.6%

Year 2: [$1,400,000 - (400,000)(1.25)(1.25)]/[($4,000,000 - 800,000)(1.25)(1.25)] = 15.5%
Year 3: [$1,620,000 - (400,000)(1.25)(1.25)(1.25)]/[($4,000,000 - 1,200,000)(1.25)(1.25)(1.25)] =
15.3%

Blooms: Apply
Difficulty: 3 Hard
performance.

14-124
Year Cash flows

1 $1,200,000
2 $1,400,000
3 $1,620,000
What is the residual income for each year, assuming the cost of capital is 15% and Marvin uses
historical costs and gross book values to compute residual income?

A. $200,000 $400,000 $620,000
B. $200,000 $200,000 $200,000
C. $250,000 $200,000 $450,000
D. $250,000 $400,000 $375,000

A. Option A
B. Option B
C. Option C
D. Option D
Year 1: ($1,200,000 - 400,000) - ($4,000,000 × .15) = $200,000

Year 2: ($1,400,000 - 400,000) - ($4,000,000 × .15) = $400,000
Year 3: ($1,620,000 - 400,000) - ($4,000,000 × .15) = $620,000

Blooms: Apply
performance.

14-125
Year Cash flows

1 $1,200,000
2 $1,400,000
3 $1,620,000
What is the residual income for each year, assuming the cost of capital is 15% and Marvin uses
historical costs and net book values to compute residual income?

A. $200,000 $435,000 $690,000
B. $260,000 $520,000 $800,000
C. $260,000 $420,000 $540,000
D. $280,000 $400,000 $750,000

A. Option A
B. Option B
C. Option C
D. Option D
Year 1: ($1,200,000 - 400,000) - [($4,000,000 - 400,000) × .15] = $260,000

Year 2: ($1,400,000 - 400,000) - [($4,000,000 - 800,000) × .15] = $520,000
Year 3: ($1,620,000 - 400,000) - [($4,000,000 - 1,200,000) × .15] = $800,000

Blooms: Apply
Difficulty: 3 Hard
performance.

14-126
straight-line depreciation and no salvage value. The Jones also purchased land and other assets, which
are not depreciable at a cost of $200,000. It is estimated that in 5-years, the value of these assets will be
unchanged. Assume that annual cash profits are $80,000 and, for return on investment (ROI)
calculations, the company uses end-of-year asset values.
What is the ROI for each year using net book value?

A. 11.1% 12.5% 14.3% 16.7%
B. 10.0% 10.0% 10.0% 10.0%
C. 10.0% 8.9% 7.3% 6.5%
D. 11.1% 11.5% 12.5% 12.3%

A. Option A
B. Option B
C. Option C
D. Option D
Year 1: ($80,000 - 40,000)/[$200,000 - 40,000 + 200,000] = 11.1%

Year 2: ($80,000 - 40,000)/[$200,000 - 80,000 + 200,000] = 12.5%
Year 3: ($80,000 - 40,000)/[$200,000 - 120,000 + 200,000] = 14.3%
Year 4: ($80,000 - 40,000)/[$200,000 - 160,000 + 200,000] = 16.7%

Blooms: Apply
performance.

14-127
What is the ROI for each year using gross book value?

A. 10.0% 9.5% 8.0% 7.9%
B. 10.0% 10.0% 10.0% 10.0%
C. 12.5% 11.0% 12.0% 15.0%
D. 10.0% 12.5% 14.0% 17.0%

A. Option A
B. Option B
C. Option C
D. Option D
Year 1: ($80,000 - 40,000)/[$200,000 + 200,000] = 10.0%

Year 2: ($80,000 - 40,000)/[$200,000 + 200,000] = 10.0%
Year 3: ($80,000 - 40,000)/[$200,000 + 200,000] = 10.0%
Year 4: ($80,000 - 40,000)/[$200,000 + 200,000] = 10.0%

Blooms: Apply
performance.

14-128
If sales each year average $840,000, what will be the asset turnover using gross book value?

A. 3.0.
B. 2.6.
C. 2.1.
D. 1.9.
$840,000/($200,000 + 200,000) = 2.1

Blooms: Remember
performance.

Essay Questions

14-129
104. Seaside Enterprises has the following data for its three divisions for the year:
SB TH GM
Revenues $1,200,000 $3,800,000 $2,800,000
Cost of sales 769,500 1,900,000 1,400,000
Allocated
corporate 72,000 228,000 210,000
overhead
Other general &
158,500 1,100,000 1,100,000
administration
Required:

a.
SB TH GM
Revenues $1,200,000 $3,800,000 $2,800,000
Cost of sales 769,500 1,900,000 1,400,000
Gross Margin 430,500 1,900,000 1,400,000
Allocated
corporate 72,000 228,000 210,000
overhead
Other general &
158,500 1,100,000 1,100,000
administration
Operating
200,000 572,000 90,000
income
Taxes 60,000 171,600 27,000
Net income 140,000 400,400 63,000
b. SB: $430,500/1,200,000 = 35.88%; TH: $1,900,000/3,800,000 = 50%; GM: $1,400,000/2,800,000 =

50%
c. SB: $200,000/1,200,000 = 16.67%; TH: $572,000/3,800,000 = 15.05%; GM: $90,000/2,800,000 =
3.21%
d. SB: $140,000/1,200,000 = 11.67%; TH: $400,400/3,800,000 = 10.54%; GM: $63,000/2,800,000 =
2.25%

Blooms: Analyze
14-130

105. La Mesa Foods has the following data for its two divisions for the year:
Uno Dos
Revenues $600,000 $1,900,000
Cost of sales 384,750 950,000
Required:

a.
Uno Dos
Revenues $600,000 $1,900,000
Cost of sales 384,750 950,000
Gross Margin 215,250 950,000
Taxes 30,000 85,800
Net income 70,000 200,200
b. Uno: $212,250/600,000 = 35.38%; Dos: $950,000/1,900,000 = 50%

c. Uno: $100,000/600,000 = 16.67%; Dos: $286,000/1,900,000 = 15.05%
d. Uno: $70,000/600,000 = 11.67%; Dos: $200,200/1,900,000 = 10.54%

Blooms: Analyze

14-131
106. Nue Wines has the following data for its three divisions for the year:
Ein Zwei Drei

Revenues $12,000,000 $38,000,000 $28,000,000
Cost of sales 7,695,000 19,000,000 14,000,000
Allocated
corporate 720,000 2,280,000 2,100,000
overhead
Other general
& 1,585,000 11,000,000 11,000,000
administration
Return on
15% 12% 9%
Investment
Required:

a.
Ein Zwei Drei

Revenues $12,000,000 $38,000,000 $28,000,000
Cost of sales 7,695,000 19,000,000 14,000,000
Allocated
corporate 720,000 2,280,000 2,100,000
overhead
Other general
& 1,585,000 11,000,000 11,000,000
administration
Operating
$2,000,000 $5,720,000 $900,000
income
Taxes 700,000 2,002,000 315,000
Net income $1,300,000 $3,718,000 $585,000
b. Ein: $1,300,000/12,000,000 = 10.83%; Zwei: $3,718,000/38,000,000 = 9.78%; Drei:

$585,000/28,000,000 = 2.09%
c. Asset turnover = ROI/profit margin ratio
Ein: 15%/10.83% = 1.39; Zwei: 12%/9.78% = 1.23; Drei: 9%/2.09% = 4.31

14-132
Blooms: Analyze

107. La Mesa Stores has the following data for its two divisions for the year:
Uno Dos
Revenues $6,000,000 $18,000,000
Cost of sales 3,769,500 9,400,000
Allocated corporate
400,000 1,200,000
overhead
Other general &
772,000 5,700,000
administration
Return on Investment 14% 12%
Required:

a.
Uno Dos
Revenues $6,000,000 $18,000,000
Cost of sales 3,769,500 9,400,000
Allocated corporate
400,000 1,200,000
overhead
Other general &
772,000 5,700,000
administration
Operating income $1,058,500 $1,700,000
Taxes 370,475 595,000
Net income $688,025 $1,105,000
b. Uno: $688,025/6,000,000 = 11.47%; Dos: $1,105,000/18,000,000 = 6.14%

c. Asset turnover = ROI/profit margin ratio
Uno: 14%/11.47% = 1.22; Dos: 12%/6.14% = 1.95

Blooms: Analyze
14-133

North South
Sales 90,100 128,445
Required:
Compute the following ratios for each division:
a. Profit margin
b. Asset turnover
c. Return on investment (ROI)

a. Profit margins
North: $15,375/90,100 = 17.1% South: $9,160/128,445 = 7.1%
b. Asset turnovers
North: $90,100/47,620 = 1.89 South: $128,445/37,690 = 3.41
c. Return on investments
North: $15,375/47,620 = 32.3% South: $9,160/37,690 = 24.3%

Blooms: Analyze

14-134
North South
Sales 90,100 128,445
Required:
The South Division has a goal to increase its ROI to 30% by the end of next year. Compute the increase
(decrease) required in each of the following items in order to achieve this goal.
a. Operating assets
b. Total costs
c. Sales

a. .30 = $9,160/assets; assets = $30,533, which is a decrease of $7,157 or 19.0%

b. .30 = ($128,445 - total cost)/$37,690; Total cost = $117,138, which is a decrease of $2,147 or 1.8%
c. .30 = (Sales - $119,285)/37,690; Sales = $130,592, which is an increase of $2,147 or 1.7%

Blooms: Analyze

14-135
14-136
110. You are the manager of an operating division of a manufacturing company. Your division has
$4,500,000 in assets, and your budgeted income statement for the current year follows:
Revenues $8,000,000
Cash costs:
Variable 1,000,000
Fixed 3,750,000
Depreciation 1,375,000
Your company uses a performance evaluation and bonus plan, which is based on return on investment
(ROI) computed with end-of-year gross asset balances.
In October, you discover that you can purchase a new machine for $3,250,000, which will enable you
to expand the output of your division and save costs. The machine would have a salvage value of
$250,000 and would be depreciated over 3-years using the straight-line method. It will increase output
by 10% while reducing cash fixed costs by 5%. If you accept the machine, it will be installed in late
December, but no depreciation will be taken on the new machine this year.
If you do buy this machine, you will have to dispose of the machine you are now using, which you just
purchased last January. That machine cost you $2,500,000 but has no salvage value. $750,000 of the
depreciation on the income statement is depreciation for this machine. In the ROI calculations, the
company includes any gains or losses for equipment disposal in income for the year. You may safely
ignore all taxes for this analysis.
Required:
a. What is your division's ROI this year if you do not acquire the new machine?
b. What is your division's ROI this year if you do acquire the new machine?
c. What is your division's expected ROI next year if the machine is acquired and meets expectations?

a. Income: $8,000,000 - 1,000,000 - 3,750,000 - 1,375,000 = $1,875,000; ROI = $1,875,000/$4,500,000

= 41.67%
b. Loss on disposal:
Purchase price $2,500,000

Less depreciation 750,000
Net book value $1,750,000
Salvage value -0-
Loss on disposal $1,750,000
Income = $1,875,000 - $1,750,000 = $125,000

Assets: $4,500,000 - $2,500,000 + $3,250,000 = $5,250,000
ROI = $125,000/$5,250,000 = 2.38%
c. Next year's income
14-137
Revenues: $8,000,000 × 110% $8,800,000
Variable cash: $1,000,000 × 110% 1,100,000
Fixed cash: $3,750,000 × 95% 3,562,500
Depreciation: 1,625,000
Income $2,512,500
Depreciation: $1,375,000 - 750,000 + [($3,250,000 - $250,000)/3] = $1,625,000

Assets: $4,500,000 - $2,500,000 + $3,250,000 = $5,250,000
ROI = $2,512,500/$5,250,000 = 47.86%

Blooms: Analyze

14-138
14-139
111. The ArtMart Company has three divisions: X Division, Y Division, and Z Division. Operating results
for the three divisions for last year were as follows:
Div X Div Y Div Z

Residual income $98,400 $27,200 $2,000
Net operating
188,600 115,600 66,000
income
Average operating
820,000 680,000 400,000
assets
Sales 1,640,000 1,445,000 1,040,000
Corporate headquarters is offering an investment opportunity to each of the divisions. The opportunity
will yield an operating income of $35,000, based on an average operating investment of $246,000.
Required:
a. If the divisions are being evaluated using return on investment (ROI), what will be the decision
(accept or reject) of each division regarding this opportunity? Support your answer with the appropriate
calculations.
b. If the divisions are being evaluated using residual income, what will be the decision (accept or reject)
of each division regarding this opportunity? Support your answer with the appropriate calculations.

a. ROI for new investment = $35,000/246,000 = 14.23%
Operating income
X: $1,640,000 × .115 = $188,600

Y: $1,445,000 × .080 = $115,600
Z: $1,040,000 × .050 = $52,000
Divisional ROI's
X: $188,600/820,000 = 23.0% (reject)

Y: $115,600/680,000 = 17.0% (reject)
Z: $66,000/400,000 = 16.5% (reject)
b. Divisional cost of capital
X: $188,600 - (cost of capital × $820,000) = $98,400; Cost of capital = 11.0%

Y: $115,600 - (cost of capital × $680,000) = $27,200; Cost of capital = 13.0%
Z: $66,000 - (cost of capital × $400,000) = $2,000; Cost of capital = 16.0%
Divisional residual income for new investment
X: $35,000 - (.11 × $246,000) = $7,940 (accept)
14-140
Y: $35,000 - (.13 × $246,000) = $3,020 (accept)
Z: $35,000 - (.16 × $246,000) = ($4,360) (reject)

Blooms: Analyze
Difficulty: 3 Hard

112. The following information is available about the status and operations for Division A of Boxwood
Division A
Required:

new ROI.

a. $70,000/$200,000 = 35%
b. ($70,000 + $16,000)/($200,000 + $60,000) = 33.08%
c. Current profit margin: $70,000/$400,000 = 17.5%; asset turnover: $400,000/$200,000 = 2 times.
New ROI = (17.5% + 1%) × 2 = 37%
d. New ROI = 17.5% × (2 + 1) = 52.5%

Blooms: Analyze

14-141
113. The following information is available about the status and operations for Division B of Boxwood
Division B
Required:

b. Division B could increase its profit by $25,000 by increasing its investment by $100,000. Compute
its new ROI.

a. $550,000/$1,500,000 = 36.67%
b. ($550,000 + $25,000)/($1,500,000 + $100,000) =35.94%
c. Current profit margin: $550,000/$3,600,000 = 15.28%; asset turnover: $3,600,000/$1,500,000 = 2.4
times. New ROI = (15.28% + 1%) × 2.4 = 39.07%
d. New ROI = 15.28% × (2.4 + 1) = 51.95%

Blooms: Analyze

14-142
114. Radner Industries is a division of a major corporation. Last year the division had total sales of
Required:


a. Margin = Net operating income ÷ Sales = $2,828,980 ÷ $23,380,000 = 12.1%

b. Turnover = Sales ÷ Average operating assets = $23,380,000 ÷ $7,000,000 = 3.3
c. ROI = Net operating income ÷ Average operating assets = $2,828,980 ÷ $7,000,000 = 40.4%

Blooms: Apply
Difficulty: 1 Easy

115. Danali Fabrication is a division of a major corporation. Last year the division had total sales of
Required:
What is the division's return on investment (ROI)?

ROI = Net operating income ÷ Average operating assets = $2,006,400 ÷ $6,000,000 = 33.4%

Blooms: Apply
Difficulty: 1 Easy

14-143
116. The following information is available about the Appliance Division of Rainier Company.
Rainier requires a return of 9% from all divisions.
Appliance Division
$18,462,000
Earnings from Operations
Appliance Division Sales $112,600,000
Appliance Division
$173,700,000
Identifiable Assets
Required:
(use four decimal places in your calculation)
a. Compute the ROI for the Appliance Division.

b. Compute the residual income for the Appliance Division.

a. 10.63%
b. $2,829,000
a. ROI = $18,462,000/$173,700,000 = 10.63%

b. $18,462,000 - (9% × 173,700,000) = $2,829,000

Blooms: Analyze

14-144
Sales $30,000,000
18%
return
Required:



d. Residual income = Net operating income - Minimum required rate of return × Average operating
assets = $1,170,000 - (18% × $8,000,000) = $(270,000)

Blooms: Apply
Difficulty: 1 Easy

14-145
Sales $33,040,000
18%
return
Required:


a. ROI = Net operating income ÷ Average operating assets = $1,453,760 ÷ $8,000,000 = 18.2%
b. Residual income = Net operating income - Minimum required rate of return × Average operating
assets = $1,453,760 - (18% × $8,000,000) = $13,760

Blooms: Apply
Difficulty: 1 Easy

14-146
119. Edmonson Corporation had net operating income of $150,000 and average operating assets of $500,000.
The company requires a return on investment of 19%.
Required:
a. Calculate the company's current return on investment and residual income.

b. The company is investigating an investment of $400,000 in a project that will generate annual net
operating income of $78,000. What is the return on investment of the project? What is the residual
income of the project? Should the company invest in this project?

a. Return on investment = Net operating income ÷ Average operating assets = $150,000 ÷ $500,000 =
30%
Residual income = Net operating income - (Average operating assets × Minimum required rate of
return) = $150,000 - ($500,000 × 0.19) = $55,000
b. Return on investment = Net operating income ÷ Average operating assets = $78,000 ÷ $400,000 =
19.5%
Residual income = Net operating income - (Average operating assets × Minimum required rate of
return) = $78,000 - ($400,000 × 0.19) = $2,000
Investment Decision: It depends on whether they evaluate on ROI or Residual Income.

If they use Residual Income, the company should invest in this project since its rate of return exceeds
the minimum required rate of return. In other words, its residual income is positive. On the other hand,
its ROI is lower and will bring down the company's ROI to 25.3%. So it really depends on the
evaluation criteria.

Blooms: Apply

14-147
120. The following information is available about the Charger Division of Weston Company. Weston
requires a return of 8% from all divisions.
Charger Division Earnings from

$12,854,000
Operations
Charger Division Sales $92,500,000
Charger Division Identifiable Assets $156,000,000
Required:
(use four decimal places in you calculation)
a. Compute the ROI for the Charger Division.

b. Compute the residual income for the Charger Division.

a. 8.24%
b. $374,000
a. ROI = $12,854,000/$156,000,000 = 8.24%

b. $12,854,000 - (8% × 156,000,000) = $374,000

Blooms: Analyze

14-148
121. The following information is available about the status and operations for Division A of Abad
Division A
Required:

b. Compute the residual income for Division A.
c. Division A could increase its profit by $8,000 by increasing its investment by $30,000. Compute its
d. Division A could increase its profit margin ratio by one percentage point (for example: from 12% to
e. Division A could reduce its investment so that its asset turnover increased by one time, while holding

a. 35%
b. $15,000
c. $17,000
d. 37%
e. 52.5%
a. $35,000/$100,000 = 35%
b. $35,000 - (20% × $100,000) = $15,000
c. ($35,000 + $8,000) - [20% × ($100,000 + $30,000)] = $17,000
d. Current profit margin: $35,000/$200,000 = 17.5%; asset turnover: $200,000/$100,000 = 2 times. New
ROI = (17.5% + 1%) × 2 = 37%
e. New ROI = 17.5% × (2 + 1) = 52.5%

Blooms: Analyze

14-149
122. The following information is available about the status and operations for Division B of Abad
Division B
Required:

b. Compute the residual income for Division B.
c. Division B could increase its profit by $10,000 by increasing its investment by $40,000. Compute its
d. Division B could increase its return on sales by one percentage point (for example: from 10% to
e. Division B could reduce its investment so that its asset turnover increased by one time, while holding

a. $275,000/$750,000 = 36.67%
b. $275,000 - (20% × $750,000) = $125,000
c. ($275,000 + $10,000) - [20% × ($750,000 + $40,000)] = $127,000
d. Current profit margin: $275,000/$1,800,000 = 15.28; asset turnover: $1,800,000/$750,000 = 2.4
times. New ROI = (15.28% + 1%) × 2.4 = 39.07%
e. New ROI = 15.28% × (2.4 + 1) = 51.95%

Blooms: Analyze

14-150
operations:
Sales $24,900,000
12%
return
Required:



d. Residual income = Net operating income - Average operating assets × Minimum required rate of
return = $1,319,700 - ($6,000,000 × 12%) = $1,319,700 - $720,000 = $599,700

Blooms: Apply
Difficulty: 1 Easy

14-151
operations:
Sales $12,700,000
16%
return
Required:


a. ROI = Net operating income ÷ Average operating assets = $1,054,100 ÷ $5,000,000 = 21.1%
b. Residual income = Net operating income - Average operating assets × Minimum required rate of
return = $1,054,100 - ($5,000,000 × 16%) = $1,054,100 - $800,000 = $254,100

Blooms: Apply
Difficulty: 1 Easy

125. Raisin Corporation uses residual income to evaluate the performance of its divisions. The minimum
required rate of return for performance evaluation purposes is 19%. The Processed Foods Division had
average operating assets of $410,000 and net operating income of $86,000 in June.
Required:
What was the Processed Foods Division's residual income in June?


Minimum required return ($410,000 × 19%) 77,900

Blooms: Apply
Difficulty: 1 Easy
14-152

126. The Parts Division of the Stein Corporation had average operating assets of $150,000 and net operating
income of $27,800 in March. The company uses residual income to evaluate the performance of its
divisions, with a minimum required rate of return of 17%.
Required:
What was the Parts Division's residual income in March?


Minimum required return
25,500
($150,000 × 17%)

Blooms: Apply
Difficulty: 1 Easy

127. Edinger Industries is a division of a major corporation. The following data are for the latest year of
operations:
Sales $20,760,000
16%
return
Required:
What is the division's residual income?

Residual income = Net operating income - Average operating assets × Minimum required rate of return
= $2,553,480 - ($6,000,000 × 16%) = $2,553,480 - $960,000 = $1,593,480

Blooms: Apply
Difficulty: 1 Easy
14-153

128. The following information is available about the status and operations for Division A of Triplex
Division A
Required:
a. Compute the residual income for Division A.

new residual income.

a. $17,500 - (10% × $100,000) = $7,500

b. ($17,500 + 4,000) - [10% × ($100,000 + 30,000)] = $8,500
c. Current profit margin: $17,500/$200,000 = 8.75%; new profit margin = 8.75% + 1% = 9.75%; 9.75%
= new profit/$200,000; new profit = $19,500; residual income = $19,500 - (10% × $100,000) = $9,500
d. Current asset turnover: $200,000/$100,000 = 2 times; new turnover = 2 + 1 = 3; 3 = $200,000/new
investment; new investment = $66,667; residual income = $17,500 - (10% × $66,667) = $10,833

Blooms: Analyze

14-154
129. The following information is available about the status and operations for Division B of Tallon
Division B
Required:
a. Compute the residual income for Division B.

b. Division B could increase its profit by $25,000 by increasing its investment by $100,000. Compute
its new residual income.

a. $550,000 - (20% × $1,500,000) = $250,000

b. ($550,000 + 25,000) - [20% × ($1,500,000 + $100,000)] = $255,000
c. Current profit margin: $550,000/$3,600,000 = 15.278%; new profit margin = 15.278% + 1% =
16.278%; 16.278% = new profit/$3,600,000; new profit = $586,008; residual income = $586,008 - (20%
× $1,500,000) = $286,008
d. Current asset turnover: $3,600,000/$1,500,000 = 2.4 times; new turnover = 2.4 + 1 = 3.4; 3.4 =
$3,600,000/new investment; new investment = $1,058,824; residual income = $550,000 - (20% ×
$1,058,824) = $338,235

Blooms: Analyze

14-155
130. The Augment Manufacturing Company has three divisions: X Division, Y Division, and Z Division.
Operating results for the three divisions for last year were as follows:
Div X Div Y Div Z

Residual income $98,400 $27,200 $12,000
Net operating
188,600 115,600 76,000
income
Average operating
820,000 680,000 400,000
assets
Sales 1,640,000 1,445,000 1,040,000
Required:
a. What is the ROI for each of the three divisions?

b. What is the cost of capital for each of the three divisions?

a. X: $188,600/820,000 = 23.0%
Y: $115,600/680,000 = 17.0%
Z: $76,000/400,000 = 19.0%
b. X: $188,600 - (cost of capital × $820,000) = $98,400; Cost of capital = 11.0%
Y: $115,600 - (cost of capital × $680,000) = $27,200; Cost of capital = 13.0%
Z: $76,000 - (cost of capital × $400,000) = $12,000; Cost of capital = 16.0%

Blooms: Analyze

14-156
131. The Butyl Division of the Swiss Corporation just started operations. It purchased depreciable assets
costing $2,500,000 with an expected life of five years, after which the assets can be salvaged for
$400,000. Depreciation is computed for the financial statements on a straight-line basis, using the
salvage value. Annual cash operating flows are $1,300,000.
Required:
a. Compute the division's return on investment (ROI) for each year, using beginning of the year asset
values, historical costs, and net book values.
b. Compute the division's return on investment (ROI) for each year, using end of the year asset values,
historical costs, and net book values.

a. Depreciation expense = ($2,500,000 - 400,000)/5 yrs = $420,000

Operating income = $1,300,000 - 420,000 = $880,000
Year Depr Exp Op Income BV beg of Yr ROI

1 $420,000 $880,000 $2,500,000 35.2%
2 420,000 880,000 2,080,000 42.3%
3 420,000 880,000 1,660,000 53.0%
4 420,000 880,000 1,240,000 71.0%
5 420,000 880,000 820,000 107.3%
b.

Year Depr Exp Op Income BV end of Yr ROI
1 420,000 880,000 2,080,000 42.3%
2 420,000 880,000 1,660,000 53.0%
3 420,000 880,000 1,240,000 71.0%
4 420,000 880,000 820,000 107.3%
5 420,000 880,000 400,000 220.0%

Blooms: Analyze
performance.

14-157
14-158
132. The Butyl Division of the Swiss Corporation just started operations. It purchased depreciable assets
costing $2,500,000 with an expected life of five years, after which the assets can be salvaged for
$400,000. Depreciation is computed for the financial statements on a straight-line basis, using the
salvage value. Annual cash operating flows are $1,300,000 for year 1. Assume that all cash flows and
asset prices increase by 12.5% per year.
Required:
a. Compute the division's ROI for the first three years, using end of the year asset values, current costs,
and net book values.
b. Compute the division's ROI for the first three years, using end of the year asset values, current costs,
and gross book values.

Depreciation expense = ($2,500,000 - 400,000)/5 yrs = $420,000

Operating income year 1 = $1,300,000 - 420,000 = $880,000
Operating income year 2 = $880,000 × 112.5% = $990,000
Operating income year 3 = $990,000 × 112.5% = $1,113,750
Book Value end of year 1
Yea Accum Pric

Gross BV NBV EoY Current
r Depr e
$2,500,00 $2,080,00
1 $420,000 × 1 2,080,000
0 0
×
2 2,500,000 840,000 1,660,000 1.12 1,867,500
5
×
1.12
1,260,00 $1,569,37
3 2,500,000 1,240,000 5 ×
0 5
1.12
5
Year Gross BV Price Current GBV

1 2,500,000 ×1 2,500,000
2 2,500,000 × 1.125 2,812,500
3 2,500,000 × 1.125 × 1.125 3,164,063
a.
Year Op Inc Current NBV ROI

1 $880,000 $2,080,000 42.3%
2 990,000 1,867,500 53.0%
3 1,113,750 1,569,375 71.0%
14-159
b.
Year Op Inc Current GBV ROI

1 $880,000 $2,500,000 35.2%
2 990,000 2,812,500 35.2%
3 1,113,750 3,164,063 35.2%

Blooms: Analyze
performance.

14-160
133. Three years ago, one division of the Calsone Enterprise Company purchased depreciable assets costing
$2,000,000. The cash flows from these assets for the past three years have been:
Year Cash Flows

1 $600,000
2 700,000
3 810,000
Calsone used the straight-line depreciation method; the estimated useful life is 10-years with no salvage
value. For return on investment (ROI) calculations, Calsone uses end-of-year balances.
Required:
a. What was the ROI for each year using historical cost and gross book value?
b. What was the ROI for each year using historical cost and net book value?

Depreciation: $2,000,000/10 = $200,000/yr
a.
Yea Cash
Depr Op Inc GBV ROI
r Flow
20.0
1 $600,000 $200,000 $400,000 $2,000,000
%
25.0
2 700,000 200,000 500,000 2,000,000
%
30.5
3 810,000 200,000 610,000 2,000,000
%
b.
Ye Cash
Depr Op Inc GBV NBV ROI
ar Flow
$600,0 $200,0 $400,0 $2,000,0 1,800,0 22.2
1
00 00 00 00 00 %
700,00 200,00 500,00 2,000,00 1,600,0 31.3
2
0 0 0 0 00 %
810,00 200,00 610,00 2,000,00 1,400,0 43.6
3
0 0 0 0 00 %

Blooms: Analyze
14-161
performance.

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

Gross margin ratio is defined as the gross margin (sales minus cost of goods sold) divided by sales. The
operating margin ratio is operating income (gross margin minus operating costs) divided by sales. The
profit margin ratio is after-tax income (operating profits less taxes) divided by sales. All three measures
have sales as the denominator. The numerators are all different measures of income.

Blooms: Remember

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

First, there may be size differences between divisions. Second, not all of the costs are controllable by
the manager. There may be allocated corporate costs included in the costs of the division.

Blooms: Remember

136. Describe the two main limitations of return on investment.

First, the accounting income and the asset base tend to focus on current activities. This can cause a
short-term focus or myopia. Second, using ROI can give incentives for the manager to concentrate on
the divisional performance and take actions that lead to lower organizational performance. This is called
suboptimization.

Blooms: Remember

14-162
137. How does the use of residual income overcome the limitations of using return on investment?

Residual income does not overcome the limitation of myopia, but it does overcome the suboptimization
limitation. Residual income overcomes suboptimization two ways. First residual income is not a ratio
measure. There is no incentive for a manager to invest in a project with a negative residual income nor
is there an incentive to reject any project with a positive residual income. Second, the comparative
benchmark implicit in residual income is the cost of capital and is not under the manager's control. The
implicit benchmark for ROI is the manager's current ROI, which is controllable.

Blooms: Remember

138. How does EVA differ from residual income?

While residual income and economic value-added measures (EVA®) have some similarities, EVA
makes adjustments to income and investment to correct accounting calculations that do not reflect the
economics of the transaction. Typical examples are capitalizing expenditures that common accounting
practice would expense, such as advertising or R&D expenditures. Residual income, on the other hand,
is the difference between profits and the cost of the assets that generate those profits. When comparing
their calculations, residual income (RI) is defined as follows:
• Investment center operating profits—(Capital charge × Investment center assets)
However, economic value added (EVA) is defined as follows:
• After-tax (adjusted) operating profits-(Cost of capital × Capital employed (adjusted))

Blooms: Remember

14-163
139. "I think that EVA is the best performance measure. I am going to recommend that we evaluate all
managers, of plants, divisions, subsidiaries, up to the chief executive officer (CEO), using it." Do you
think this statement is appropriate? Explain.

The problem with using the same measure of performance for managers at all levels in an organization
is that managers' responsibilities and decision rights differ. For example, a plant manager might not
have the authority to choose where to produce or what equipment to use. EVA, however, evaluates the
manager on how well he or she uses assets.

Blooms: Remember

140. 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?

Gross book value results in a constant denominator in the ROI calculation unless assets are acquired or
disposed. This will result in a constant ROI unless there are changing prices. Net book value is
computed by taking depreciation into account in the asset base. The asset base will constantly be
decreasing (unless there are acquisitions and disposals) resulting in a constantly increasing ROI. It could
be the case that the increasing ROI leads to a conclusion that performance is increasing when in fact no
changes are occurring and the asset base is just depreciating.

Blooms: Remember
performance.

14-164
141. What is the problem with choosing a beginning, ending or average balance when measuring the
investment base for performance evaluation?

Using the beginning balance could encourage asset acquisitions early in the year to increase income for
the entire year. Asset dispositions would be encouraged at the end of the year to reduce the investment
base for next year. If end-of-year balances are used, similar incentives to manipulate purchases and
dispositions exist. Average investments would tend to minimize this problem, although computing
average investments could be more difficult. In choosing an investment base, management must balance
the costs of the additional computations required for average investment against the potential negative
consequences of using the beginning or ending balances. In general, how a performance measure is used
is more important than how it is calculated.

Blooms: Remember
performance.

14-165
14-166
142. Financial data for Windsor, Inc. for last year appear below:
Windsor, Inc.
Beginning Ending

Balance Balance
Assets:
Cash $250,000 $260,000
Inventory 230,000 205,000
Investment in Pine Company 220,000 250,000
Total assets $1,670,000 $1,660,000
Liabilities and stockholders'

equity:
Stockholders’ equity 710,000 720,000
Total liabilities and
$1,670,000 $1,660,000
Stockholders’ equity
Windsor, Inc.
Income Statement
Sales $1,750,000
Less operating expenses 1,470,000
Tax expense 70,000 166,000
Net income $114,000
The company paid dividends of $104,000 last year. The "Investment in Pine Company" on the
statement of financial position represents an investment in the stock of another company.
Required:
b. The Board of Directors of Windsor, Inc. has set a minimum required return of 25%. What was the

a. Operating assets do not include investments in other companies or in undeveloped land.
14-167
Beginning Ending

Balance Balance
Cash $250,000 $260,000
Inventory 230,000 205,000
Total operating assets $1,020,000 $980,000
Average operating assets = ($1,020,000 + $980,000) ÷ 2 = $1,000,000

Margin = Net operating income ÷ Sales = $280,000 ÷ $1,750,000 = 16%
Turnover = Sales ÷ Average operating assets = $1,750,000 ÷ $1,000,000 = 1.75
ROI = Margin × Turnover = 16% × 1.75 = 28%
b. Residual income = Net operating income - Average operating assets × Minimum required rate of
return = $280,000 - ($1,000,000 × 25%) = $280,000 - $250,000 = $30,000

Blooms: Apply

14-168
14-169
143. Financial data for Beaker Company for last year appear below:
Beaker Company
Beginning Ending

Balance Balance
Assets:
Cash $50,000 $70,000
Inventory 30,000 35,000
Investment in Cedar Company 80,000 100,000
Total assets $470,000 $510,000
Liabilities and owners' equity:
Owners' equity 150,000 170,000
Total liabilities and owners'
$470,000 $510,000
equity
Beaker Company
Income Statement
Sales $414,000
Less operating expenses 351,900
Tax expense 10,000 40,000
Net income $22,100
The company paid dividends of $2,100 last year. The "Investment in Cedar Company" on the statement
of financial position represents an investment in the stock of another company.
Required:
b. The Board of Directors of Beaker Company has set a minimum required return of 20%. What was
the company's residual income last year?

a. Operating assets do not include investments in other companies or in undeveloped land.
14-170
Beginning Ending

Balance Balance
Cash $50,000 $70,000
Inventory 30,000 35,000
Total operating assets $220,000 $240,000
Average operating assets = ($220,000 + $240,000) ÷ 2 = $230,000
Margin = Net operating income ÷ Sales = $62,100 ÷ $414,000 = 15%
Turnover = Sales ÷ Average operating assets = $414,000 ÷ $230,000 = 1.8
ROI = Margin × Turnover = 15% × 1.8 = 27%
b.

Minimum required return (20% × $230,000) 46,000

Blooms: Apply

14-171
144. Xi, Inc. is just starting up. The management team has decided from the beginning that decentralization
was the preferred organizational style and has made this clear in all interviews and discussions with
potential employees. Mr. Yang, the CEO, is unsure about the best way to evaluate his division
managers. He has heard the terms return on investment, residual income, economic value added, and
flexible budgets but wants to know the pros and cons of each.
Required:
Briefly describe ROI, residual income, EVA and other approaches to performance evaluation. Include in
your discussion, where appropriate, how to calculate the measure and problem areas in the development
of some of the results.

Formulas: ROI = divisional income/divisional invested capital = (divisional income/divisional sales

revenue) times (divisional sales revenue/divisional invested capital)
Residual income = divisional income - (divisional invested capital × imputed interest rate) where the
imputed interest rate is the minimum desired rate of return on invested capital.
EVA = divisional after-tax operating income - (divisional total assets - divisional current liabilities)
(WACC)
All three approaches use invested capital and divisional profit. Invested capital may be calculated using
total assets or total productive assets (which are total assets less current liabilities) A second issue
relates to the method of measuring the invested capital: gross book value or net book value. One might
say that net book value has some advantages because it is the approach used on the balance sheet and
the income statement but it uses depreciation methods that are somewhat arbitrary and as time passes
the ROI can increase just because the net book value of the assets declines. Common, centrally
controlled assets need to be allocated to the investment centers, e.g. cash, accounts receivable.
Divisional income is measured using the concept of controllability; deciding which items are controlled
by the division manager may not be clear cut.
Alternative approaches include flexible budgets, variance analysis, and postaudits of major investment
decisions. While these are more complicated approaches, they help avoid the myopic problems of the
single-period measures such as ROI, RI, and EVA.

AICPA: FN Reporting
Blooms: Apply
Difficulty: 3 Hard

14-172
145. Mrs. Young is the manager of the Children's Toy division of Ferguson Corporation. Every year she just
misses the cut off established by the company for the awarding of bonuses. She is concerned inasmuch
as she believes she is running her division effectively and her income has been increasing slowly but
steadily over the years she has been with the company.
She knows that the company uses ROI as the performance measure to evaluate divisions and begins to
study the formula to see what she should do to improve the ROI for her division.
Required:
Briefly discuss several ways to improve ROI.

ROI = income/invested capital = (income/sales revenue) × (sales revenue/invested capital) = sales

margin × capital turnover
Looking at the formula shows that there are two components that might be looked at for improving the
end result, capital turnover and sales margin.
If the capital turnover is held constant, the sales margin can be improved either by decreasing unit sales
by increasing the selling price (the idea being to hold the total sales revenue constant or increase it a bit)
or decreasing costs. The first approach would work to decrease total variable costs related to units sold
because fewer units would be involved which would raise the income. The problem here would be that
raising the selling price might actually lead to lower total sales revenue because the company would
lose more sales than it wanted.
Decreasing costs while holding everything else constant would work to increase income. Depending on
which costs were decreased, the company might lose sales due to poor quality products or less customer
service.
If the sales margin is held constant, the capital turnover can be improved by either increasing sales
revenue or reducing the division's invested capital. Invested capital can by reduced in the short-run by
reducing inventories. The idea of reducing inventories ties in with JIT but there could be problems if the
reductions lead to stockouts and lost sales.
Sales revenue can be increased by using the store space more effectively, e.g. pack more displays into
the existing space. This could turn customers away because the overall store atmosphere has
deteriorated; customers may become unhappy with the more crowded layout.

AICPA: FN Reporting
Blooms: Apply

14-173
146. Decentralization is lauded as important to good management. But it is not without its problems.
Required:
Identify the advantages and disadvantages of decentralization? How do ROI, Residual Income, and
EVA affect these issues?

Advantages include
• When individuals are given decision-making opportunities and autonomy, they take ownership of
their decisions, hopefully, leading to better decisions.
• When decision-makings is delegated to the lowest possible level in the organization, individuals can
react quickly to opportunities and threats and take advantage of their expertise.
• Giving the individual with the most knowledge and specialization in an area, often individuals at low
level of power, more decision making authority should lead to better decisions and greater levels of
motivation.
• Allowing individuals to make decisions and manage autonomously will provide training for the
future.
• When people are given ownership of their decisions they make better decisions and devote the highest
and best level of managerial effort.
• Allowing lower level managers to make decisions frees up time from upper management to devote to
strategic decisions.
Disadvantages
• A lack of goal congruence can result from decentralization. If individuals are making decisions in
their own best interest, they may not be making them in the overall company best interest.
• Decentralization may mean the duplication of decision making - which can result in an inefficient use
of resources and a lack of consistency in decision making.
• Individuals making decisions at lower levels might have a narrow focus and be unable to see the "big
picture."
ROI, Residual Income and EVA can be used as management evaluation tools. Bonuses and rewards are
often based upon maintaining or increasing ROI, Residual Income, and EVA.
• Their use can enhance a focus on the individual department, but may further the problems of
decentralization.
• Their use allows managers to focus on profit, but not a balanced score card.
• Their use allows comparisons among managers and subunits with different levels of resources.
• Their use can encourage investment or inhibit investment if used improperly.
• When the overall company ROI, Residual Income, and EVA are used as well as those of the
individual department, some decentralization problems are reduced.

14-174
AICPA: FN Reporting
Blooms: Apply

14-175
147. Mallory, Inc. has the following data available for two of its divisions for last year:
Asian European

Division Division
Sales $460,000 $900,000
Contribution Margin 184,000 470,000
Weighted average cost of
14% 14%
capital
The imputed interest for Mallory, Inc. is 24%.

The tax rate for Mallory, Inc. is 18%.
Required:
(1) Compute the following for each division:

(a) Sales margin.
(b) Capital turnover.
(c) ROI.
(d) Residual income.
(e) EVA (assume there are no current liabilities).
(2) Briefly discuss which division appears most successful and why?

(1)
(a) Asian Sales margin = $92,000/$460,000 = 20%

European Sales margin = $90,000/$900,000 = 10%
(b) Asian Capital turnover = $460,000/$368,000 = 1.25
European Capital turnover = $900,000/$750,000 = 1.20
(c) Asian ROI = $92,000/$368,000 = 25%
European ROI = $90,000/$750,000 = 12%
(d) Asian Residual income = $92,000 - (.24 × 368,000) = $3,680
European Residual income = $90,000 - (.24 × 750,000) = $(90,000)
(e) Asian EVA = [$92,000 × (1 - .18)] - [.14 × (368,000 - 0)] = $23,920
European EVA = [$90,000 × (1 - .18)] - [.14 × (750,000 - 0)] = $(31,200)
(2) The Asian Division has exceeded the target ROI, has a positive residual income and a higher EVA.
Using these single point estimates, Asian Division appears to be the better division.

AICPA: FN Reporting
Blooms: Apply
14-176

148. Roxie, Inc. has used a decentralized form of organizational structure for the past five years. The
controller, Ms. Hamburg, has noticed that some of the divisions are still using fixed assets that are fully
depreciated and that there has been little acquisition activity in these divisions. Coupled with this are
very high ROIs, especially when compared to the other divisions that seem to have a regular program of
disposition and replacement of fixed assets.
She takes her concerns and observations to the Financial Vice President who says he will review her
findings and look into the problem.
Required:
1) What are the potential negative effects of decentralization?

2) Specifically discuss the issues involved in suboptimization.

(1) (a) Managers in a decentralized organization sometimes have a narrow focus on their unit's
performance, rather than the attainment of their organization's overall goals.
(b) As a result of this narrow focus, managers may tend to ignore the consequences of their actions on
the organization's other subunits.
(c) In a decentralized organization, some tasks or services may be duplicated unnecessarily.
(2) The divisions with the high ROI and low replacements of fixed assets are comparing the returns on
potential replacements to their own high ROI and rejecting the replacements because they do not meet
this number. Their fear is that these replacements would reduce their ROI, a valid concern because the
invested capital component of the ROI formula would increase.
The suboptimization occurs if these replacements meet the company's minimum desired rate of return
on invested capital; it would have been to the overall benefit of the company to acquire the assets. This
is the type of issue addressed by residual income.

AICPA: FN Reporting
Blooms: Apply

14-177
14-178
149. Tran Company has the following financial statements for the year ended December 31, 2016.
Tran Company
Balance Sheet
For 2016
Cash $1,600,000
Accounts Receivable 3,000,000
Inventory 2,500,000
Current Assets $7,100,000
Long-Lived Assets 14,500,000
Total Assets $21,600,000
Current Liabilities $1,200,000
Long-Term Debt 2,400,000
Shareholder Equity 18,000,000
Total Debt and Equity $21,600,000
Tran Company
Income Statement
Sales $20,000,000
Cost of Sales 15,000,000
Gross Margin $5,000,000
Operating Expenses 2,500,000
Operating Income $2,500,000
Taxes 1,000,000
Tran Company
Cash Flows from Operations
Plus Depreciation Expense 1,000,000
+ Decrease (- Increase) in Acct. Rec. &
---
Inventory
+ Increase (- Decrease) in Current
---
Liabilities
Cash Flows from Operations $2,500,000
Some additional information about 2016 includes:
Industry
Tran
Data
Year End Stock Price $23.00
Number of Shares
1,800,000
Outstanding
14-179
Sales Multiplier 2.10
Free Cash Flow Multiplier 22.00
Earnings Multiplier 18.00
Accounts Receivable
6.60
Turnover
Inventory Turnover 5.80
Current Ratio 2.20
Quick Ratio 1.50
Cash flows from Operations
1.50
Ratio
Free Cash Flow Ratio 1.00
Gross Margin Percentage 30%
Return on Assets (Net Book
18%
Value)
Return on Equity 22%
Training Expense $500,000
Income Tax Rate 40%
Depreciation Expense $1,000,000
Dividends ---
Required:
1. Complete a business analysis of Tran Company for 2016.

2. Complete a business valuation for Tran Company for 2016.

1. Note: capital invested for EVA includes: Average total assets + training expenses - current liabilities
Economic Value Added

+ Training Expense 500,000
- Cost of Capital (1,045,000)
Economic Value Added $955,000
Industr
Financial Ratios 2016
y
Accounts Receivable Turnover 6.67 6.60
Inventory Turnover 6.00 5.80
Current Ratio 5.92 2.20
Quick Ratio 3.83 1.50
Cash Flow Ratios
14-180
Cash Flow from Operations 2.08 1.50
Free Cash Flow 2.08 1.00
Gross Margin Percentage 25% 30%
Return on Assets (Net Book Value) 6.6% 18%
Return on Equity 8.7% 22%
Tran looks good on all liquidity ratios but falls short on all profitability ratios. Economic value added is
positive, in part due to the relatively high amount of training expenses in 2016.
2.
Business Valuation 2016

Book Value of Equity $18,000,000
Market Value of Equity 41,400,000
Discounted Free Cash = free cash flow × (1/cost of capital rate); assumes cash flows of
50,000,000
Flows continuing life
Multiples-Based

Valuation
Earnings Multiple $27,000,000 = earnings × industry multiple
Free Cash Flow Multiple 55,000,000 = free cash flow × industry multiple
Sales Multiple 42,000,000 = sales × industry multiple
The valuation measures vary somewhat, but the discounted cash flow measure is often the most
reliable, and in this case falls on the upper end of the range of valuations. The median valuation would
be approximately $45,000,000.

AICPA: FN Reporting
Blooms: Apply

14-181
14-182
150. Suade Inc. manufactures furniture and is organized into three large divisions: bedroom, living room, and
dining room furniture. The following information presents operating revenues, operating incomes and
invested assets of the company over the last three years. (all figures in 000s)
Operating Revenues 2016 2017 2018

Dining Room $8,000 $15,000 $16,000
Living Room 4,500 3,600 2,400
Bedroom 8,800 7,600 6,600
Operating Income
Dining Room $2,500 $3,100 $1,800
Bedroom 1,200 1,500 1,600
Invested Assets
Dining Room $12,000 $12,500 $12,500
Living Room 2,500 2,400 2,200
Bedroom 4,500 4,700 4,900
The following table shows the number of managers covered by the current compensation package of
Suade Inc.:

Dining Room 300 350 375
Bedroom 120 140 175
The current compensation package is an annual bonus award. The managers share in the bonus pool.
The pool is calculated as 12% of the annual residual income of the company. The residual income is
defined as operating income minus an interest charge of 15% of invested assets.
Required:
(1) Use investment turnover, return on sales, and ROI to explain the differences in profitability of the
three divisions.
(3) If the bonus were calculated by divisional residual income what would be the bonus amounts?
(4) Discuss the benefits and problems of basing the bonus on residual income of a company compared
to using divisional residual income.

(1)
Return on Sales 2016 2017 2018
14-183
Dining Room 0.313 0.207 0.113
Living Room 0.100 0.250 0.250
Bedroom 0.136 0.197 0.242
Asset Turnover
Dining Room 0.667 1.200 1.280
Living Room 1.800 1.500 1.091
Bedroom 1.956 1.617 1.347
Return on Investment
Dining Room 0.208 0.248 0.144
Living Room 0.180 0.375 0.273
Bedroom 0.267 0.319 0.327
(2) (Operating Income - (.15 × Invested Assets)) × .12 = Bonus Amount

Products Inc. (multiply each bonus by 1,000 since all figures in the information above are in thousands)
2016 [4,150 - (.15 × 19,000)] × .12 × 1,000 = $156,000

2017 [5,500 - (.15 × 19,600)] × .12 × 1,000 = $307,200
2018 [4,000 - (.15 × 19,600)] × .12 × 1,000 = $127,200
Bonus Amount/Number of Executives = Average Bonus
2016 $156,000/460 = $339

2017 $307,200/530 = $580
2018 $127,200/587 = $217
(3) Dining Room
2016 [2,500 - (.15 × 12,000)] × .12 × 1,000 = $84,000

2017 [3,100 - (.15 × 12,500)] × .12 × 1,000 = $147,000
2018 [1,800 - (.15 × 12,500)] × .12 × 1,000 = $(9,000)
Living room
2016 [450 - (.15 × 2,500)] × .12 × 1,000 = $9,000

2017 [900 - (.15 × 2,400)] × .12 × 1,000 = $64,800
2018 [600 - (.15 × 2,200)] × .12 × 1,000 = $32,400
Bedroom
2016 [1,200 - (.15 × 4,500)] × .12 × 1,000 = $63,000

2017 [1,500 - (.15 × 4,700)] × .12 × 1,000 = $95,400
2018 [1,600 - (.15 × 4,900)] × .12 × 1,000 = $103,800
(4) Pros: The company wide bonus plan promotes the sharing of corporate-wide assets. The bonus plan
also helps to keep talented managers that are running divisions that are not able to perform up to
expectations. Cons: The company-wide bonus plan includes many factors not under the control of each
divisional managers. The bonus plan also penalizes executives of profitable divisions that do not receive
14-184
the total benefit because of unprofitable divisions.

AICPA: FN Reporting
Blooms: Apply

14-185
14-186
151. The High Seas, Inc. manufactures water vessels and is organized into three large divisions: jet skis,
fishing boats, and yachts. The following information presents operating revenues, operating incomes,
and invested assets of the company over the last three years:
Operating Revenues
2016 2017 2018
(all figures in $000s)
Jet Skis $2,000 $3,000 $4,000
Fishing Boats 5,000 5,000 4,000
Yachts 8,000 7,000 8,000
Operating Income
Jet Skis $500 $700 $1,000
Fishing Boats 3,000 2,500 2,000
Yachts 4,000 3,000 3,500
Invested Assets
Jet Skis $1,200 $1,500 $2,000
Fishing Boats $2,000 $1,500 $1,500
Yachts 3,000 2,500 3,000
The following table shows the number of managers covered by the current compensation package of
The High Seas, Inc.:

Jet Skis 50 60 70
Fishing Boats 200 180 160
Yachts 250 200 250
The current compensation package is an annual bonus award. The managers share in the bonus pool.
The pool is calculated as 10% of the annual residual income of the company. The residual income is
defined as operating income minus an interest charge of 14% of invested assets.
Required:
(2) If the bonus was calculated by divisional residual income, what would be the bonus amounts?

(1) The High Seas, Inc. (multiply each bonus by 1,000 since all figures above are in thousands)
(Operating Income - (.14 × Invested Assets)) × .10 = Bonus Amount
2016 [7,500 - (.14 × 6,200)] × .10 × 1,000 = $663,200

2017 [6,200 - (.14 × 5,500)] × .10 × 1,000 = $543,000
2018 [6,500 - (.14 × 6,500)] × .10 × 1,000 = $559,000
Bonus Amount/Number of Executives = Average Bonus
14-187
2016 $663,200/500 = $1,326.40
2017 $543,000/440 = $1,234.09
2018 $559,000/480 = $1,164.58
(2) Jet Skis
2016 [500 - (.14 × 1,200)] × .10 × 1,000 = $33,200

2017 [700 - (.14 × 1,500)] × .10 × 1,000 = $49,000
2018 [1,000 - (.14 × 2,000)] × .10 × 1,000 = $72,000
Fishing Boats
2016 [3,000 - (.14 × 2,000)] × .10 × 1,000 = $272,000

2017 [2,500 - (.14 × 1,500)] × .10 × 1,000 = $229,000
2018 [2,000 - (.14 × 1,500)] × .10 × 1,000 = $179,000
Yachts
2016 [4,000 - (.14 × 3,000)] × .10 × 1,000 = $358,000

2017 [3,000 - (.14 × 2,500)] × .10 × 1,000 = $265,000
2018 [3,500 - (.14 × 3,000)] × .10 × 1,000 = $308,000

AICPA: FN Reporting
Blooms: Apply

14-188

Business Unit Performance Measurement: True / False Questions

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What are some of the performance measures discussed in the document?

What are some of the performance measures discussed in the document?

What is residual income and how is it calculated?

What is residual income and how is it calculated?

Chapter 14

Business Unit Performance Measurement

True / False Questions

Multiple Choice Questions

(A) Divisional income statements do not include allocated common costs.

A. gross margin ratio.

A. gross margin ratio.

A. gross margin ratio.

A. ROI uses accounting income which is based on historical costs.

A. reducing the asset turnover.

South West East

Which division has the smallest return on investment (ROI)?

South West East

Which division has the largest asset turnover?

South West East

Which division's profit margin is the highest?

Original cost of the asset $20,000

Original cost of the asset $20,000

Original cost of the asset $20,000

What is Sweet Dreams Company's return on investment (ROI)?

Sales Equipment Investment

A. (4/6) × (6/1) = ROI

Zootime's return on investment was:

A. sales by the same dollar amount.

A. Sales in the denominator.

Sales Average Operating Assets

A. 12% and 16%.

The margin in Year 2 was:

Sales in Year 2 amounted to:

Average operating assets in Year 1 were:

Net operating income in Year 2 amounted to:

Unit selling price $20

A. An increase in sales.

A. Increase in average operating assets.

A. Only (A) is true.

(A) Residual income can be used to compare divisions of different sizes.

A. Only (A) is false.

A. residual income can be computed without regard to identifying an investment base.

A. Bella Vista Service Co. has a return on investment of 4%.

A. Historical weighted average cost of capital.

What is Kiss Company's residual income?

Return on investment (ROI) 15.0%

Compute the Door Division's residual income.

What was A Division's residual income last year?

What was B Division's return on investment (ROI) last year?

What was C Division's cost of capital last year?

A. Fixed assets employed in division operations.

A. Research & development costs.

A. Research & development costs.

A. Research & development costs.

A. Only (A) is true.

A. historical costs and net book values.

A. early in the year and dispose of assets late in the year.

A. early in the year and dispose of assets late in the year.

Year Cash flows