Question

#5

REVISED PROBLEM 13-42

ACC 650 - Management Accounting

Megatronics Corporation, a massive retailer of electronic products, is organized in four separate divisions.
The four divisional managers are evaluated at year-end, and bonuses are awarded based on ROI.
Last year, the company as a whole produced a 13 percent return on its investment.
During the past week, management of the company’s Northeast Division was approached about the
possibility of buying a competitor that had decided to redirect its retail activities. (If the competitor is
acquired, it will be acquired at its book value.) The data that follow relate to recent performance of the
Northeast Division and the competitor:

	NE DIVISION	COMPETITOR
SALES	$8,600,000	$4,250,000
VARIABLE COSTS	75% of sales	60% of sales
FIXED COSTS	$1,800,000	$1,600,000
INVESTED CAPITAL	$3,100,000	$225,000

Management has determined that in order to upgrade the competitor to Megatronics’ standards, an
additional $275,000 of invested capital would be needed.

REQUIRED:

5. Assume that Megatronics uses residual income to evaluate performance and desires a 12 percent
minimum return on invested capital. Compute the current residual income of the Northeast
Division and the division’s residual income if the competitor is acquired. Will divisional management
be likely to change its attitude toward the acquisition? Why?

Answer 1

Statement showing calculation of Residual Income under both the options:

Particulars	Northeast Division	Competitor	NE division + Competitor
(A) Sales	$ 8,600,000	$ 4,250,000	$ 12,850,000
(B) Variable cost	$ 6,450,000 (75% of Sales)	$ 2,550,000 (60% of Sales)	$ 9,000,000
(C) Contribution [(A)-(B)]	$ 2,150,000	$ 1,700,000	$ 3,850,000
(D) Fixed cost	$ 1,800,000	$ 1,600,000	$ 3,400,000
(E) Profit/(loss)	$ 350,000	$ 100,000	$ 450,000

Therefore, residual income of Northeast Division is $ 350,000 and if competitor is acquired, residual income is $ 450,000.

Minimum required return on capital invested is 12%.

Capital investment required under both the options will be:

Option 1 = $ 3,100,000

Option 2 = $ 3,600,000 ($ 3,100,000 + $ 225,000 + $ 275,000)

Northeast division = ($ 350,000 / $ 3,100,000) x 100 = 11.29%

Combined with competitor = ($ 450,000 / $ 3,600,000) x 100 = 12.5%

Yes, divisional management will likely to change its attitude toward acquisition. Because, Northeast division alone is not able to earn its benchmark return on capital invested. But if competitor is acquired, it is able to earn return more than the benchmark return of 12% on capital invested as combined return is 12.5%.