Albrecht 19.pdf - Marriott School

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966 Part 6 Control in a Management Accounting System
The following examples show how each of the three alternatives increases ROI:
1. Increase ROI by reducing expenses by $400,000, providing a segment operating
profit of $1,400,000:
$1,400,000
$10,000,000
14% 2 28%
ROI
2. Increase ROI by reducing average total assets to $4,000,000:
$1,000,000
$10,000,000
$10,000,000
$5,000,000
$10,000,000
$4,000,000
10% 2.5 25%
ROI
3. Increase ROI by increasing revenue to $12,000,000 (assume that operating profit increases
proportionately): 6 ROI
$1,200,000
$12,000,000
$12,000,000
$5,000,000
residual income
The amount of operating
profit earned above a
specified minimum rate of
return on assets; used
to evaluate investment
centers.
10% 2.4 24%
Although ROI is an effective way of evaluating managers of investment centers, it has certain
drawbacks. For example, assume that an investment center currently has an ROI of
22%, but the company has an overall ROI of only 16%. If a new project or investment that
promises a return of 19% becomes available to the investment center manager, it might
be rejected because the investment center’s overall ROI would be reduced, even though
the company’s overall ROI would be increased.
Residual Income
Although ROI is widely used to evaluate investment centers, because of its drawbacks,
some companies use a closely related measure called residual income,
which is the amount of operating profit an investment center is able to earn
above a certain minimum rate of return on assets. The formula for residual income
is as follows:
Operating profit (Minimum required rate of return Average total assets) Residual income
To illustrate, let’s return to Acme Computer and calculate its residual income.
Assuming that the specified minimum rate of return on assets at IMC is 15%, Acme
Computer needs to earn at least $750,000 (15% $5,000,000 average total assets) before
it can report any residual income. We then compute Acme Computer’s residual income
as follows:
$1,000,000 segment margin $750,000 minimum return on assets $250,000 residual income
To further illustrate why many companies prefer to use residual income over ROI for
evaluating investment center performance, assume that Acme Computer has an opportunity
to invest $1,200,000 in a new project that will generate a return of 16% ($192,000
per year). If Acme Computer’s manager is being evaluated on ROI, she would probably
reject this investment opportunity because, as the following analysis shows, it would reduce
the division’s overall ROI from 20% to 19.2%.
6 As will be discussed in Chapter 20, operating profit is likely to increase more than proportionately when revenue rises.
Because some costs (such as rent) are fixed in amount, operating profit should increase to more than 10% when revenue increases
10%. As a result, the ROI in this example should actually increase to more than 24%.