Question

For many years, Lawton Industries has manufactured prefabricated houses where the houses are constructed in sections to be assembled on customers’ lots. The company expanded into the precut housing market in 2006 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, thus, established the Presser Division as an investment center of Lawton.

              Lawton uses return on average investment (ROI) as a performance measure the investment defined as operating assets employed. Management bonuses are based in part on ROI. All investments in operating assets are expected to earn a minimum return of 15% before income taxes. Presser’s ROI has ranged from 19.3% to 22.1% since it was acquired in 2006. The division had an investment opportunity in the year just ended that had an estimated ROI of 18%, but Presser’s management decided against the investment because it believed the investment would decrease the division’s overall ROI.

              Presser’s operating statement for the year just ended is presented next. The division’s operating assets employed were $12,600,000 at the end of the year, a 5% increase over the balance at the end of the previous year.

_______________________________________________________________________

                                                          Presser Division Operating Statement

                                                                  For the year ended Dec. 31

                                                                             ($000 omitted)

_______________________________________________________________________

              Sales Revenue                                                                                                                   $24,000

              Cost of Goods Sold                                                                                                              15,800

                   Gross Profit                                                                                                                      $8,200

              Operating Expenses

              Administrative                                                                          $2,140

              Selling                                                                                         3,600                              5,740

              Income from operations

                   Before income taxes                                                                                                      $2,460

_______________________________________________________________________

Questions

1. Calculate these performance measures for the year just ended for the Presser Division of Lawton Industries:

1. Return on average investment in operating assets employed (ROI).
2. Residual income calculated on the basis of average operating assets employed.

2. Would the management of Presser Division have been more likely to accept the investment opportunity it had during the year if residual income were used as a performance measure instead of ROI? Explain your answer.

The Presser Division is a separate investment center with Lawton Industries. Identify and describe the items Presser must control if it is to be evaluated fairly by either the ROI or residual income performance measures

Answer 1

Requirement 1

Computation of average investment in operating assets employed

Balance at end of current year	12,600,000
Balance at end of previous year (12,600,000/1.05)	12,000,000
Total	$ 24,600,000
Average operating assets employed	12,300,000
$ 24,600,000/2

ROI = Income from operations ÷ Average operating assets employed = 2,460,000 / 12,300,000 = 20%

Residual income
Income from operations	2,460,000
Less: Minimum return on assets employed 12300,000 *0.15	1,845,000
Residual income	$ 615,000

Requirement 2

It’s affirmative if presser’s management had accepted the investment as it had residual income. The acceptance would have lowered ROI as expected return of 18% is lower than historical return of division and actual ROI of 20% as well.

The management rejected investment as bonuses were based on performance. If management uses residual income as performance measure to give bonus, management would accept any and all investments increasing residual income.

Requirement 3

Pressure is advised to control items related to revenues and expenses and investment as it would be evaluated as investment centre if ROI or residual income is satisfactory. Hence, Pressure shall control basically whole of business except investment capital which is being taken control by Lawton Industries.

kindly upvote