Question

Exercise 13-29 ROI; Residual Income (LO 13-1, 13-2)

[The following information applies to the questions displayed below.]

Wyalusing Industries has manufactured prefabricated houses for over 20 years. The houses are constructed in sections to be assembled on customers’ lots. Wyalusing expanded into the precut housing market when it acquired Fairmont Company, one of its suppliers. In this market, various types of lumber are precut into the appropriate lengths, banded into packages, and shipped to customers’ lots for assembly. Wyalusing designated the Fairmont Division as an investment center. Wyalusing uses return on investment (ROI) as a performance measure with investment defined as average productive assets. Management bonuses are based in part on ROI. All investments are expected to earn a minimum return of 12 percent before income taxes. Fairmont’s ROI has ranged from 29.4 to 32.6 percent since it was acquired. Fairmont had an investment opportunity in 20x1 that had an estimated ROI of 28 percent. Fairmont’s management decided against the investment because it believed the investment would decrease the division’s overall ROI. The 20x1 income statement for Fairmont Division follows. The division’s productive assets were $27,300,000 at the end of 20x1, a 5 percent increase over the balance at the beginning of the year.

FAIRMONT DIVISION
Income Statement
For the Year Ended December 31, 20x1
(in thousands)
Sales revenue				$	63,990
Cost of goods sold					33,600
Gross margin				$	30,390
Operating expenses:
Administrative	$	4,480
Selling		17,915			22,395
Income from operations before income taxes				$	7,995

Exercise 13-29 Part 1

Required:

1. 1-a. Calculate the return on investment (ROI) for 20x1 for the Fairmont Division.

2. 1-b. Calculate residual income for 20x1 for the Fairmont Division.

2. Would the management of Fairmont Division have been more likely to accept the investment opportunity it had in 20x1 if residual income were used as a performance measure instead of ROI?

Answer 1

(1)(a)-The return on investment (ROI) for 20x1 for the Fairmont Division.

Average Investment = [($27,300,000 x 100/105) + $27,300,000] / 2

= ($26,000,000 + $27,300,000) / 2

= $53,300,000 / 2

= $26,650,000

Therefore, the return on investment (ROI) = [Net Income / Average Investment] x 100

= [$7,995,000 / $26,650,000] x 100

= 30.00%

(1)(b)-The Residual income for 20x1 for the Fairmont Division.

Residual income for 20x1 for the Fairmont Division = Income from Investment – [Average investment – Minimum required rate of return]

= $7,995,000 – [$26,650,000 x 12.00%]

= $7,995,000 - $3,198,000

= $4,797,000

(2)-YES. The management of Fairmont Division should accept the Investment opportunity since it has the higher residual income of $4,797,000.