Cost Accounting: Responsibility Accounting-( Evaluating New Investment Using Return on Investment...

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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




= ( 9,00,000 / 100,00,0000 ) × ( 100,00,000 / 50,00,000)

= 0.09 × 2

= 0.18 or 18 %

Division C




= ( 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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