Question

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

Answer 1

1.Return on Investment is calculated by dividing the operating income by the average assets employed. Higher the return on investment, better it is. There is a certain percentage which is known as the required rate of return. If the return on investment is lower than the required rate of return, the project/division's performance is unacceptable, If it is higher, it is accepted.

Residual Income refers to the income remaining after charging the required rate of return form the operating income. It shows the extra/shortfall earnings on the project/division.

If the residual income is positive, the performance is acceptable, It it is not, the project is not acceptable.

2. Capital Budgets are prepared for long term investments of the company. These budgets are for planning in long-lived assets requiring huge investment and affecting company for a long period of time. Operating budgets are the budgets prepared for the day to day operating needs of the business. It is based on the operating cycle of the company.