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Question: How is RI calculated?

Short Answer

Expert verified

Answer

Residual income is computed by taking the difference between operating income and targeted return.

Step by step solution

01

Meaning of Operating Income

Operating income refers to the income generated by a business entity from its core operations. It is computed by taking the difference between sales revenue and associated costs such as variable and fixed.

02

Computation of residual income

Residual income is the difference between operating income and the target rate of return on the company’s average total assets.

The formula for computing residual income is as follows:

Residualincome=Operatingincome-(Targetrateofreturn×Averagetotalassets)

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Most popular questions from this chapter

Refer to the information in Short Exercise S24-7.

Requirements

1. Compute each division’s asset turnover ratio (round to two decimal places). Interpret your results.

2. Use your answers to Requirement 1, along with the profit margin ratio, to recalculate ROI using the expanded formula. Do your answers agree with the basic ROI in Short Exercise S24-7?

XTreme Sports Company makes snowboards, downhill skis, cross-country skis, skateboards, surfboards, and inline skates. The company has found it beneficial to split operations into two divisions based on the climate required for the sport: Snow Sports and Non-snow Sports. The following divisional information is available for the past year:

Net Sales Revenue

Operating Income

Average Total Assets

ROI

Snow Sports

\(5,500,000

\)990,000

$4,100,000

24.1%

Non-snow Sports

8,500,000

1,530,000

6,100,000

25.1%

XTreme’s management has specified a 13% target rate of return. Calculate each division’s profit margin ratio.

Interpret your results.

Grandpa Jim’s Cookie Company sells homemade cookies made with organic ingredients. His sales are strictly Web based. The business is taking off more than Grandpa Jim ever expected, with orders coming from across the country from both consumers and corporate event planners. Grandpa decides to decentralize and hires a full-time baker who will manage production and product costs and a Web site designer/sales manager who will focus on increasing sales through the Web site. Grandpa Jim can no longer handle the business on his own, so he hires a business manager to work with the other employees to ensure the company is best utilizing its assets to produce profit. Grandpa will then have time to focus on new product development. Now that Grandpa Jim’s Cookie Company has decentralized, identify the type of responsibility center that each manager is managing

Using ROI and RI to evaluate investment centers

Tiger Paints is a national paint manufacturer and retailer. The company is segmented into five divisions: Paint Stores (branded retail locations), Consumer (paint sold through home improvement stores), Automotive (sales to auto manufacturers), International, and Administration. The following is selected divisional information for its two largest divisions: Paint Stores and Consumer:

Net Sales Revenue Operating Income Average Total Assets

Paint Stores\( 4,000,000 \) 476,000 $ 1,420,000

Consumer 1,300,000 196,000 1,585,000

Management has specified a 19% target rate of return.

Requirements

1. Calculate each division’s ROI. Round all of your answers to four decimal places.

2. Calculate each division’s profit margin ratio. Interpret your results.

3. Calculate each division’s asset turnover ratio. Interpret your results.

4. Use the expanded ROI formula to confirm your results from Requirement 1. Interpret your results.

5. Calculate each division’s RI. Interpret your results, and offer a recommendation for any division with negative RI.

6. Describe some of the factors that management considers when setting its minimum target rate of return.

Henderson Company manufactures electronics. The Calculator Division (an investment center) manufactures handheld calculators. The division can purchase the batteries used in the calculators from the Battery Division (another investment center) or from an outside vendor. The cost to purchase batteries from the outside vendor is \(5. The transfer price to purchase from the Battery Division is \)6. The Battery Division also sells to outside customers. The sales price is \(6, and the variable cost is \)3. The Battery Division has excess capacity.

Requirements

1. Should the Calculator Division purchase from the Battery Division or the outside vendor?

2. If Henderson Company allows division managers to negotiate transfer prices, what is the maximum transfer price the manager of the Calculator Division should consider?

3. What is the minimum transfer price the manager of the Battery Division should consider?

4. Does your answer to Requirement 3 change if the Battery Division is operating at capacity?

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