Raddington Industries produces tool and die machinery for various manufacturers. Two years ago, the company expanded vertically by acquiring Regis Steel Company, one of its suppliers of alloy steel plates. In order to manage the two separate businesses, the operations of Regis Steel 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 the investment defined as average operating assets used. Raddington has a policy of basing all employee bonuses on divisional ROI. All investments in operating assets are expected to earn a minimum return of 11 percent before income taxes. Regis’s cost of goods sold is considered to be entirely variable, whereas the division’s administrative expenses are not dependent on volume. Selling expenses are a mixed cost, with 40 percent attributed to sales volume. Over the last two years, Regis’s ROI has ranged from 11.8 percent to 14.7 percent. During the fiscal year ended November 30, 2009, Regis contemplated a capital acquisition with an estimated ROI of 11.5 percent; however, division management decided against the investment because it believed that the investment would decrease Regis’s overall ROI. The 2009 income statement for Regis is presented below. The division’s operating assets were $15,750,000 on November 30, 2009, a 5 percent increase over the 2008 year-end balance.
Regis Steel Division Operating Statement
For the year ended November 30, 2009
Sales revenue .................. $25,000
Cost of goods sold ................ $16,500
Gross profit .................. $ 8,500
Administrative expenses ............ 3,955
Selling expenses ................ 2,700
Income from operations before income taxes ..... $ 1,845
A. Calculate the unit contribution for Regis Steel Division if 1,484,000 units were produced and sold during the year ended November 30, 2009.
B. Calculate the return on investment (ROI) for Regis Steel Division for 2009.
C. Calculate the residual income using the average operating assets employed for 2009 for the Regis Steel Division.
D. Explain why the management of Regis Steel Division would have been more likely to accept the contemplated acquisition if residual income rather than ROI were used as a performance measure.
E. The Regis Steel Division is a separate investment center within Raddington Industries.
Identify several items that Regis Steel should control if it is to be evaluated fairly by either the ROI or residual income performance measure.