Wyalusing Industries has manufactured prefabricated houses for over 20 years. The houses are constructed in sections to be assembled on customers’ lots. Wyalusing expanded into the precut housing market when it acquired Fairmont 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. Wyalusing designated the Fairmont Division as an investment center. Wyalusing uses return on investment (ROI) as a performance measure with investment defined as average productive assets. Management bonuses are based in part on ROI. All investments are expected to earn a minimum return of 16 percent before income taxes. Fairmont’s ROI has ranged from 29. 2 to 32. 4 percent since it was acquired. Fairmont had an investment opportunity in 20x1 that had an estimated ROI of 28 percent. Fairmont’s management decided against the investment because it believed the investment would decrease the division’s overall ROI. The 20x1 income statement for Fairmont Division follows. The division’s productive assets were $23,100,000 at the end of 20x1, a 5 percent increase over the balance at the beginning of the year.

Fairmont Division Income Statement For the Year Ended December 31, 20x1 (in thousands) Sales revenue 22,500 Cost of goods sold 13,900 Gross margin 8,600 Operating Expenses: Administrative 1,800 Selling 4,300 6,100 Income from operations before income taxes 2,500.

Required:

1. Calculate the following perofrmance measures for 20x1 for the Fairmont Division.

a. Return on Investment (ROI)

b. Residual Income

2. Would the management of Fairmont Division have been more likely to accept the investment opportunity it had in 20X1 if residual income were used as a performance measure instead of ROI? Explain your answer

A performance measure is a technique that measures outcomes or results, enabling management, lenders, and investors to gauge the effectiveness and efficiency of their investments.

A performance measure may be applied to the following resources:

Human resources
Employee time
Funding
Investments.

Data and Calculations:

Required minimum return = 16% before taxes

Ending productive assets = $23,100,000

Beginning productive assets = $22,000,000 ($23,100,000/1.05)

Average productive assets = $22,550,000 ($23,100,000 + $22,000,000)/2

Return on Investment = Income from operations before income taxes/Average productive assets x 100

= $2,500/$22,550 x 100

= 11.09%

Residual Income = Income before taxes - Cost of Capital or (Average productive assets x Minimum Required Returns)

= $2,500,000- ($22,550,000 x 16%)

= $2,500,000 - $3,608,000

= ($1,108,000)

Thus, while the Return on Investment (ROI) is 11.09%, the Residual Income is ($1,108,000).

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