Lawton Industries has manufactured prefabricated houses for over 20 years. The houses are constructed in sections to be assembled on customers’ lots.
Lawton expanded into the precut housing market several years ago when it acquired Presser 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. Lawton decided to maintain Presser’s separate identity and, therefore, established the Presser Division as an investment center of Lawton.
Lawton uses return on investment (ROI) as a performance measure. Management bonuses are based in part on ROI. All investments in operating assets are expected to earn a minimum return of 15 percent before income taxes.
Presser’s ROI has ranged from 19 to 22 percent since it was acquired by Lawton. During the past year, Presser had an investment opportunity that had an estimated ROI of 18 percent. Presser’s management decided against the investment because it believed the investment would decrease the division’s overall ROI.
Last year’s (2014) income statement for Presser Division is given below.
The division’s operating assets employed were $15,500,000 at the end of 2014, which represents a 24 percent increase over the 2013 year end balance.
(Several purchases of new equipment were made during 2014.)
Divisional Income Statement
For the Year Ended December 31, 2014
Cost of goods sold 24,600,000
Gross margin $10,400,000
Less operating expenses:
Administrative 1,900,000 7,600,000
Net operating income $2,800,000
1. Calculate the following performance measures for Presser for 2014:
a. Return on investment (ROI)
b. Residual income (RI)
2. Would the management of Presser Division have been more likely to accept the investment opportunity it had in 2014 if residual income were used as a performance measure instead of ROI? Explain.
3. The Presser Division is a separate investment center within Lawton Industries. Identify the items which Presser Division must be free to control if it is to be evaluated fairly by either ROI or residual income.
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