Question

Demons Ltd has two retail divisions, which reported the following results for the
financial year ending 30 June 2019.

Computer Television
Contribution margin $650 000 $200 000
Controllable margin $450 000 $100 000
Average operating assets 3 000 000 500 000
Return on Investment (ROI) 15% 20%

Required:
(a) Based on the ROI information provided above, which division was more
successful? Explain your answer. Explain also whether you agree with this
conclusion.
(b) Calculate each division’s Residual Income if the firm’s minimum required rate of
return is 12%.
(c) In what way can the use of ROI as a performance measure lead to bad
decisions? How does the RI approach overcome this problem?

Answer 1

Solution a)

As per the given ROI information, television division was more successful with an ROI of 20% when compared to computer division with an ROI of 15%.

ROI is derived by dividing the net profit by the cost of investment. A higher percentage indicates high profitability. Therefore on the basis of ROI, it can be said that the television division has performed efficiently earning higher returns.

Performance of a division cannot be concluded merely on the basis of ROI. ROI lays emphasis on the short term profitability. The computer division may have incurred expenditure or taken any other measure to improve upon their ROI in the future. This fact may not be known if ROI is solely taken as a measure to evaluate the performance of a division.

Solution b)

Residual income = Controllable Margin - (Required return* Average Operating Assets)

Residual income of Computer division = $ 450000 - ( 12% * $ 3000000) = $ 450000 - $ 360000 = $ 90000

Residual income of Television division = $ 100000 - ( 12% * $ 500000) = $ 100000 - $ 60000 = $ 40000

Solution c)

Resources of an entity may not be allocated appropriately if ROI is used as a performance measure. In order to maintain the high ROI of a particular division, the divisional manager may refrain from making investments in that division. The division may earn good returns out of such investments even if it lowers the ROI which is currently high.

Returns which are higher than the desired rate of returns may be considered as good returns. This is what is emphasised in the Residual income approach. Under this approach the managers tend to focus on divisions earning returns which are higher than the minimum or desired rate of return. This would facilitate effective allocation of resources among the divisions.