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ReportOn
Responsibility Accounting
Evaluating New InvestmentUsing Return on Investment(ROI) and Residual Income
(RI)
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PREPARED FOR:
Course Instructor
EASTERN UNIVERSITY
PREPARED BY:
IMRAN HOSSAIN
ID: 103600022
IFA IQBAL
ID: 11260
MD. ARAFAT RAHMAN
ID: 1123000
MASUDUN NABI CHOWDHURY
ID: 112600010
SHAYEADUN NESSA
ID: 103600006
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DATE OF SUBMISSION: September 21, 2011Letter of Transmittal
September 21, 2011
Course Instructor
Faculty of Business Administration
Eastern University.
Dear Sir,
We submit here the report that you asked for and gave us the authorization to work on
certain field. The topic that you have given me is really an important & interesting fact
for the students. With the textual studies, acquiring practical orientation is necessary of
which you have created a big chance for us must help us to work with efficiency in
future.
Kindly accept our report and oblige us thereby. Your excellent power of thinking helps us
to build up a valuable carrier in future. Thank you for encouraging us for working on this
topic.
Yours’ sincerely,
On Behalf of Group,
---------------------
Imran Hossain
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Acknowledgement
Making a report is such a thing of pleasure. But doing this is also a tough thing. With the
help of some people I finally was able to finish the task that was assigned to us by the
course instructor. While doing this summary I faced some problems and with the help of
those people I overcame those problems. For that, we are really grateful to some guys.
And we want to acknowledge my gratitude to them.
First of all we would like to thank the almighty Allah who has given us the required
knowledge and the power to finish this report. Then we would like to thank the course
instructor. We are also very grateful to him because he followed us to the right way to
complete a task. His assistance was remarkable and very fruitful. He provided sufficient
information when needed.
Finally I would like to thank all the reader and user of this report.
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Responsibility Accounting:
Responsibility accounting is an underlying concept of accounting performance
measurement systems. The basic idea is that large diversified organizations are difficult,
if not impossible to manage as a single segment, thus they must be decentralized or
separated into manageable parts. These parts or segments are referred to as responsibility
centers that include: 1) revenue centers, 2) cost centers, 3) profit centers and 4)
investment centers. This approach allows responsibility to be assigned to the segment
managers that have the greatest amount of influence over the key elements to be
managed. These elements include revenue for a revenue center (a segment that mainly
generates revenue with relatively little costs), costs for a cost center (a segment that
generates costs, but no revenue), a measure of profitability for a profit center (a segment
that generates both revenue and costs) and return on investment (ROI) for an investment
center (a segment such as a division of a company where the manager controls the
acquisition and utilization of assets, as well as revenue and costs).
Responsibility Accounting is a system has a Responsibility centre which is a division or
department in the organization for them to be responsible for their performance.
There are basically the following four types of Responsibility centers:
COST CENTRE
Here, the manager is responsible for costs. Examples like the manager for Purchasing
department and Maintenance department
REVENUE CENTRE
Here, the manager is responsible for generating sales. A typical example is the Sales
Department.
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PROFIT CENTRE
The manager is responsible for both revenue and cost. The reason been Revenue minus
Cost is the Profit. The manager is therefore overall responsible or accountable for
making profit for the company. A company has many restaurants which are all profit
centre. A manager is assigned to each restaurant to make sure it is a profit centre.
INVESTMENT CENTRE
An example of an investment centre is a Corporate division responsible for project
investments. Here, the manager is responsible for the investments which include all the
revenue, costs and investments (invested capital or assets).
Advantages and Disadvantages of Responsibility accounting:
Responsibility accounting has been an accepted part of traditional accounting control
systems for many years because it provides an organization with a number of advantages.
Perhaps the most compelling argument for the responsibility accounting approach is that
it provides a way to manage an organization that would otherwise be unmanageable. In
addition, assigning responsibility to lower level managers allows higher level managers
to pursue other activities such as long term planning and policy making. It also provides a
way to motivate lower level managers and workers. Managers and workers in an
individualistic system tend to be motivated by measurements that emphasize their
individual performances.
ROI:
Return on Investment. A widely used measure of business success that relates net income
to invested capital (total assets). ROI provides a standard for evaluating how efficiently
management uses the average dollar (or unit of currency) invested in assets, whether the
investment came from owners or creditors. A higher ROI may also result in a higher
return.
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There are two ways of calculating ROI: the traditional formula and the DuPont formula.
The traditional approach presents a single, static measure of a company's past
performance. In contrast, the approach developed by the DuPont Corporation uses two
factors, net profit margin and total asset turnover, to measure success — in recognition of
the fact that excessive funds tied up in assets can be just as much of a drag on
profitability as excessive expenses.
Formula:
ROI = (Net Profit Margin) x (Total Asset Turnover)
ROI = (Net Profit after Taxes ÷ Sales) x (Sales ÷ Total Assets)
Turnover:
1. In accounting, the number of times an asset is replaced during a financial period.
2. The number of shares traded for a period as a percentage of the total shares in a
portfolio or of an exchange.
NOI:
A company's operating income after operating expenses are deducted, but before income
taxes and interest are deducted. If this is a positive value, it is referred to as net operating
income, while a negative value is called a net operating loss (NOL).
Residual Income:
Residual income is the net operating income that an investment center earns above
the minimum required return on its operating assets.
Residual income is another approach to measuring an investment center's
performance. Economic Value Added (EVA) is an adoption of residual income that
has recently been adopted by many companies.
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When residual income or Economic Value Added (EVA) is used to measure
managerial performance, the objective is to maximize the total amount of residual
income or EVA, not to maximize return on investment (ROI).
Comparison of return on investment (ROI) and residual income:
One of the primary reasons why controllers of companies would like to switch from ROI
to residual income has to do with how managers view new investment under the two
performance measurement schemes. The residual income approach encourages managers
to make investments that are profitable for the entire company but that would be rejected
by managers who are evaluated by ROI formula.
Basically, a manager who is evaluated based on ROI will reject any project whose rate of
return is below the division's current ROI even if the rate of return on the project is above
the minimum rate of return for the entire company. In contrast, any project whose rate of
return is above the minimum required rate of return of the company will result in an
increase in residual income. Since it is in the best interest of the company as a whole to
accept any project whose rate of return is above the minimum rate of return, managers
who are evaluated on residual income will tend to make better decisions concerning
investment projects than manager who are evaluated based on ROI.
Exercise 12-10:
1. Computation of ROI:
Division A
ROI = Margin × Turnover
Net operating income Sales= ×
Sales Average operating
= ( 3,00,000 / 60,00,0000 ) × ( 60,00,000 / 15,00,000
= 0.05 × 4
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= 0.20 or 20 %
Division B
ROI = Margin × Turnover
Net operating income Sales= ×
Sales Average operating
= ( 9,00,000 / 100,00,0000 ) × ( 100,00,000 / 50,00,000)
= 0.09 × 2
= 0.18 or 18 %
Division C
ROI = Margin × Turnover
Net operating income Sales= ×
Sales Average operating
= ( 1,80,000 / 80,00,0000 )*( 80,00,000 / 20,00,000)
= 0.0225 × 4
= 0.09 or 9 %
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2.
Computation of Residual Income:
Particulars Division A Division B Division C
Avg. Operating Assets (a) 15,00,000 50,00,000 20,00,000
Net Operating Income 3,00,000 9,00,000 1,80,000
Minimum Required Rate Of Return: 15 % 18 % 12 %
Return on Operating Asset 17% on (a) (2,55,000) (8,50,000) (3,40,000)
Residual Income 45,000 50,000 (1,60,000)
3. a. and b.
Division
A
Division
B
Division
C
ROI Return on investment (ROI)............... 20% 18% 9%
Therefore, if the division is presented
with an investment opportunity
yielding 17%, it probably would..... Reject Reject Accept
R IMinimum required return for
computing Residual Income............ 15% 18% 12%
Therefore, if the division is presented
with an investment opportunity
Accept Reject Accept
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yielding 17%, it probably would.....
3. Why Accept or Reject?
a) If performance is being measured by ROI, both Division A and Division B
probably would reject the 17% investment opportunity. These divisions’ ROIs
currently exceed 17%; accepting a new investment with a 17 % rate of return
would reduce their overall ROIs. Division C probably would accept the 17%
investment opportunity because accepting it would increase the division’s overall
rate of return.
b) If performance is measured by residual income, both Division A and Division C
probably would accept the 17% investment opportunity. The 17% rate of return
promised by the new investment is greater than their required rates of return of
15% and 12%, respectively, and would therefore add to the total amount of their
residual income. Division B would reject the opportunity because the 17% return
on the new investment is less than its 18% required rate of return.
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