Question

When the Essex Company formed three divisions a year ago, the president told the division managers an annual bonus would be given to the most profitable division. The bonus would be based on either the return on investment or residual income of the division. Investment is to be measured using gross book value or net book value. The following data are available:

Division	Book value	Operating, Inc.
A	$500,000	$53,500
B	$480,000	$52,000
C	$300,000	$33,300

            All the assets are long-lived assets that were purchased 15 years ago and have 15 years of useful life remaining. A zero terminal disposal price is predicted. Essex's minimum return on investment used for computing residual income is 10%.

            Required:

            Which method for computing profitability would each manager choose? Show supporting calculations. Where applicable, assume straight line depreciation.

Answer 1

Essex Company formed three divisions a year ago, the president decided the division managers an annual bonus would be given to the most profitable division. The bonus would be based on either the return on investment (Book Value & Net Book Value). Theses Calculation are given below:- (Return on Investment)

Division Gross Book Value Operating Income    Return on investment

A $ 500,000    $ 53,500 53500/500000*100= 10.70%

B   $ 480,000    $ 52,000 52000/480000*100= 10.83%

C    $ 300,000    $ 33,300 33,300/300000*100= 11.10%

(Return on Investment - Net Book Value)

Division Net  Book Value Operating Income    Return on investment

A $ 500,000/30*15 =250,000    $ 53,500 53500/250000*100= 21.40%

B   $ 480,000/30*15 = 240,000 $ 52,000 52000/240000*100= 21.67%

C    $ 300,000/30*15 = 150,000 $ 33,300 33,300/150000*100= 22.22%

Compute on Residual Income

Division Operating Income Less: Assumed Cost of Capital Residual Income   

A $ 53,500 $ 50,000 $ 3,500

B $ 52,000 $ 48,000    $ 4,000   

C    $ 33,300 $ 30,000 $ 3,300

Manager of B Division wants to Residual Income Method for computing profitability and Manager of C Division will want to Return on Investment Method for computing profitability.