Problem

Raddington Industries is a manufacturer of tool and die machinery. Raddington is a vertically integrated company that is organized into two divisions. The Reigis Steel Division manufactures alloy steel plates. The Tool and Die Machinery Division uses the alloy steel plates to make machines. Raddington operates each of its divisions as an investment center.

Raddington monitors its divisions on the basis of return on investment (ROI) with investment defined as average operating assets employed. Raddington uses ROI to determine management bonuses. All investments in operating assets are expected to earn a minimum return of 11% before income taxes. For many years, Reigis's ROI has ranged from 11.8% to 14.7%. During the fiscal year ended December 31, 19_8, Reigis contemplated a capital acquisition with an estimated ROI of 11.5%; division management, however, decided against the investment because it believed that the investment would decrease Reigis's overall ROI.

Reigis's 19_8 operating income statement follows. The division's operating assets employed were $15,750,000 at December 31, 19_8, a 5% increase over the 19_7 year-end balance.

Reigis Steel Division Operating Income Statement for the Year Ended December 31, 19_8

Revenue                                                          $25,000,000
            Cost of goods sold                                          16,500,000
            Gross margin                                                       8,500,000
            Operating costs
               Administrative                     $3,955,000                                         
               Marketing                              2,700,000                             
                  Operating costs                                            6,655,000
            Operating income                                            $ 1,845,000

Required

1. Calculate the return on investment and residual income for 19_8 for the Reigis Steel Division. What other information would you need to calculate EVA?

2. Would the management of Reigis Steel Division have been more likely to accept the investment opportunity it had in 19_8 if residual income were used as a performance measure instead of ROI? Explain.

3. For each of the following questions, indicate whether the margin and turnover will increase, decrease, or remain unchanged as a result of the events described below (no need to compute), and then compute the new ROI figure. Consider each question separately, starting in each case from the original ROI computed in (1) above.

a.   By use of JIT to control the purchase of some items of raw materials, the company is able to reduce the average level of inventory by $1,000,000.

b. Sales are increased by $1000,000; operating assets remain unchanged.

c. Obsolete items of inventory carried on the records at a cost of $200,000 are scrapped and written off as a loss.