HOLIDAY ENTERTAINMENT CORPORATION

MANAGEMENT ACCOUNTING

Maria Arlene (Bam) T. DisimulacionLiwayway Limbaga

Holiday Entertainment Corporation

If New Age Industries continues to use ROI as the sole measure of divisional performance, explain why Holiday Entertainment Corporation would be reluctant to acquire Recreational Leasing, Inc.

If New Age Industries continues to use return on investment as the sole measure of division performance, HEC would be reluctant to acquire RLI because the combined return on investment would decrease.

ROI = Income/Investment desired ROI is 20%

HEC ROI = $2,000,000/$8,000,000 = 0.25

RLI ROI = $600,000/$3,200,000 = 0.1875

Combined ROI = $2,600,000/$11,200,000 = 0.232

The asset cost used for RLI is the post-acquisition cost of $3,200,000, not the pre-acquisition value of assets

This would result in JSC managers either losing or having their bonuses limited to 50% of the eligible amounts, which assumes management could provide convincing explanations for the decline in ROI.

ADVANTAGES OF THE ROI MEASURE

•Helps managers focus on the relationship between sales, expenses and investment.

•Encourages cost efficiency•Discourages excessive investment in operating assets

DISADVANTAGES OF THE ROI MEASURE

•Discourages managers from investing in projects decreasing divisional ROI but increasing profitability of the company overall•Encourages managers to focus on the short-term at the expense of the long-term.

If New Age Industries could be persuaded to use residual income to measure the performance of HEC, explain why HEC would be more willing to acquire RLI.

Holiday Entertainment Corporation

If New Age Industries could be persuaded to use residual income to measure performance, JSC would be more willing to acquire RLI because the residual income of the combined operation would be larger than the residual income for JSC alone.

Residual Income = Income – (Investment x Target ROI)bonuses based on 15% cost of capital

HEC residual income = $2,000,000 – ($8,000,000 0.15) = $800,000

RLI residual income = $600,000 – ($3,200,000 0.15) = $120,000

Combined residual income = $800,000 + $120,000 = $920,000

RESIDUAL INCOME

is the difference between operating income and the minimum dollar return required on an investment.

RESIDUAL INCOME

encourages investment in all projects that earn at least the minimum rate of return.

Discuss how the behavior of division managers is likely to be affected by the use of the following performance measures:(a) ROI(b) residual income

Holiday Entertainment Corporation

The likely effect on the behavior of division managers whose performance is measured by:

(a) Return on investment includes considerations

•Put off capital improvements or modernization to avoid capital expenditures

•Shy away from profitable opportunities or investmentthat would yield more than the company’s cost of capital but which may lower overall ROI.

The likely effect on the behavior of division managers whose performance is measured by:

(b) Residual income includes considerations to

•Seek any opportunity or investment that will earn morethan the cost of capital target rate

•Seek to reduce the level of assets employed in the business.

THANK YOU

Maria Arlene (Bam) T. DisimulacionLiwayway Limbaga