Question:
(ROI; RI) Morton Industrial produces stamping machinery for manufacturers. In 2009, the company expanded vertically by acquiring a supplier, Lancaster Company. Lancaster is now operated as a divisional investment center.
Morton monitors its divisions on the basis of both unit contribution and return on investment (ROI), with investment defined as average operating assets employed. Management bonuses are determined based on ROI. All investments in operating assets are expected to earn a minimum return of 10 percent before income taxes.
Lancaster's cost of goods sold is entirely variable, whereas the division's administrative expenses are totally fixed. Selling expenses are a mixed cost with 40 percent attributed to sales volume. Last year, Lancaster's ROI was 13.6 percent. During the fiscal year ended November 30, 2010, Lancaster contemplated a capital acquisition with an estimated ROI of 11.5 percent; however, division management decided that the investment would decrease Lancaster's overall ROI.
The division's operating assets employed were $15,750,000 at November 30, 2010,a 5 percent increase over the 2009 year-end balance. The division's 2010 income statement follows.
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LANCASTER DIVISION
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Income Statement
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For the Year Ended November 30, 2010
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($000 omitted)
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Sales revenue
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$ 25,000
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Less expenses
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Cost of goods sold
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$16,500
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Administrative expenses
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3,955
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Selling expenses
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2,700
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(23,155)
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Income from operations before income taxes
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$ 1,845
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a. Calculate the segment margin for the Lancaster Division, assuming that 1,484,000 units were produced and sold during the year ended November 30, 2010.
b. Calculate the following performance measures for 2010 for the Lancaster Division:
1. pre-tax ROI, and
2. residual income calculated on the basis of average operating assets employed.
c. Explain why the management of the Lancaster Division would have been more likely to accept the contemplated capital acquisition if residual income rather than ROI were used as a performance measure.
d. Identify several items that Lancaster should control if it is to be evaluated fairly by either the ROI or residual income performance measures.