How is the performance of an investment center measured? What is the advantage of measuring residual...

How is the performance of an investment center measured? What is the advantage of measuring residual income as well as ROI?

Solutions

Expert Solution

Investment Center;
-These are those centers, which are responsible for incurring costs, generating revenues as well as, making direct investments to maximise their returns.
-As it has the authority to directly deal in investments, the performance of an Investment center is measured by calculating the Return on Investment (ROI) made by it.

ROI = Net Income/Invested Capital*100
This basically tells, the benefit the company is receiving, by making a particular investment.

*There are some issues in using ROI to measure the performance of various investment centres.
-Firstly, it computes the performance in percentage terms, which doesn’t give a clear picture.
-Secondly, the results of various divisions can be manipulated.

To overcome these problems, there is yet another approach known as Residual Income that measures the performance in absolute terms.

Residual Income = Actual Income from Investment - Desired Income
where,
Desired Income = Invested Capital * Desired rate (which is Cost of capital)

Advantages of measuring Residual Income as well as ROI;

The advantage of measuring both ROI and Residual Income, is that we get a clearer picture about the performance of investment centers, both in percentage and absolute terms.
Also, by using Residual Income, we can compare the actual performance with the desired one. If actual income exceeds the desire, the division is more profitable in absolute terms.

ekkarill92 answered 1 year ago

Next > < Previous

Related Solutions

1. Discuss how return on investment and residual income are used to evaluate investment center performance...

1. Discuss how return on investment and residual income are used to evaluate investment center performance 2. Compare and contrast capital budgets from operating budgets

In Unit 3, we look at measuring the performance of a profit center. To do this,...

In Unit 3, we look at measuring the performance of a profit center. To do this, we have to allocate the various indirect costs and service department costs to the profit centers to better gauge their profitability. However, by doing so, we attribute many costs that are not directly controlled by the unit's management (i.e. depreciation, advertising, etc.). In these cases, why is it important to still allocate these costs? At what level of management should these costs be relevant...

In what way can the use of ROI as a performance measure for an investment center...

In what way can the use of ROI as a performance measure for an investment center lead to bad decisions? How does the residual income approach overcome this problem? Discuss how this could impact motivation of managers If a company switches from using ROI to residual income as a measure of performance.

Looking at measuring the performance of a profit center. We have to allocate the various indirect...

Looking at measuring the performance of a profit center. We have to allocate the various indirect costs and service department costs to the profit centers to better gauge their profitability. However, by doing so, we attribute many costs that are not directly controlled by the unit's management (i.e. depreciation, advertising, etc.). In these cases, why is it important to still allocate these costs? At what level of management should these costs be relevant when determining that manager's performance? What would...

In Unit 3 (specifically chapter 22), we look at measuring the performance of a profit center....

In Unit 3 (specifically chapter 22), we look at measuring the performance of a profit center. To do this, we have to allocate the various indirect costs and service department costs to the profit centers to better gauge their profitability. However, by doing so, we attribute many costs that are not directly controlled by the unit's management (i.e. depreciation, advertising, etc.). In these cases, why is it important to still allocate these costs? At what level of management should these...

2. What is a cost center and how is its performance evaluated?

Discuss style portfolios. How is their performance measured?

Which one of the following is a distinguishing charactertisitc of an investment center? A) performance can...

Which one of the following is a distinguishing charactertisitc of an investment center? A) performance can be evaluated with both profitability and return on utilizing assets B) It includes significant uncontrollable fixed costs C) This type of responsbility center only generates revenues D) Revenues are rarely generated by selling products

Subjects