Question

ROI, Residual Income

Raddington Industries produces tool and die machinery for manufacturers. The company expanded vertically in 20x1 by acquiring one of its suppliers of alloy steel plates, Keimer Steel Company. To manage the two separate businesses, the operations of Keimer are reported separately as an investment center.

Raddington monitors its divisions on the basis of both unit contribution and return on average investment (ROI), with investment defined as average operating assets employed. Management bonuses are determined on ROI. All investments in operating assets are expected to earn a minimum return of 22 percent before income taxes.

Keimer's cost of goods sold is considered to be entirely variable, while the division's administrative expenses are not dependent on volume. Selling expenses are a mixed cost with 40 percent attributed to sales volume. Keimer contemplated a capital acquisition with an estimated ROI of 23.50 percent; however, division management decided against the investment because it believed that the investment would decrease Keimer's overall ROI.

The 20x2 operating statement for Keimer follows. The division's operating assets employed were $11,700,000 at November 30, 20x2, a 4 percent increase over the 20x1 year-end balance.

Keimer Steel Company Operating Statement For the Year Ended November 30, 20x2
Sales revenue				$25,640,000
Less expenses:
Cost of goods sold		$16,153,200
Administrative expenses		3,939,700
Selling expenses		2,800,000		22,892,900
Operating income before income taxes				$2,747,100

Required:

1. Calculate the unit contribution for Keimer Steel Company if 1,196,500 units were produced and sold during the year ended November 30, 20x2. Round your answer to the nearest cent.
$ per unit

2. Calculate the following performance measures for 20x2 for Keimer Steel Company:

a. Pretax return on average investment in operating assets employed (ROI). Round your percentage answer to two decimal places (for example, the decimal .10555 would be entered as "10.56" percent).
%

b. Residual income calculated on the basis of average operating assets employed.
$

3. Explain why the management of Keimer Steel Company would have been more likely to accept the contemplated capital acquisition if residual income rather than ROI were used as a performance measure.

4. Keimer Steel Company is a separate investment center within Raddington Industries. Identify several items that Keimer should control if it is to be evaluated fairly by either the ROI or residual income performance measures. (CMA adapted)

Answer 1

1) Unit contribution for Keimer Steel

Sales per unit	$21.43
Less: variable expenses
COGS	$13.50
selling expenses(40%)	$0.94
Contribution margin per unit	$6.99

2a) ROI = EBIT / average operating assers

= 2747100 / 11700000

= 23.48%

b) Residual income = Net operating income - (minimum requires return rate * avergae operating assets)

= 2747100 - (22%*11700000)

= $1,73,100

3) Management of Kiemer Steel would more likely have been able to accpet the contemplated capital acquisition if residual income rather than ROI were used as a performance measure becuase the company has a positive residual income which means that is it earning more than the required return and hence is favourable. Whereas the management believes that the overall ROI of Kiemer will decrease.