Report On

Responsibility Accounting

Evaluating New Investment Using Return on Investment (ROI) and Residual Income (RI)

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, 2011

Letter 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 iii

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. v

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:

ROI = Margin Turnover = Net operating income Sales Sales Average operating assets

Division A

= ( 3,00,000 / 60,00,0000 ) ( 60,00,000 / 15,00,000 = 0.05 4

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= 0.20 or 20 %

ROI = Margin Turnover = Net operating income Sales Sales Average operating assets

Division B

= ( 9,00,000 / 100,00,0000 ) ( 100,00,000 / 50,00,000) = 0.09 2 = 0.18 or 18 %

ROI = Margin Turnover = Net operating income Sales Sales Average operating assets

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
Avg. Operating Assets (a) Net Operating Income Minimum Required Rate Of Return: Return on Operating Asset 17% on (a) Residual Income

Division A
15,00,000 3,00,000 15 % (2,55,000) 45,000

Division B
50,00,000 9,00,000 18 % (8,50,000) 50,000

Division C
20,00,000 1,80,000 12 % (3,40,000) (1,60,000)

3. a. and b. Division A ROI Return on investment (ROI)............... Therefore, if the division is presented with an investment opportunity yielding 17%, it probably would..... Minimum required return for R I computing Residual Income............ Therefore, if the division is presented with an investment opportunity
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Division B 18%

Division C 9%

20%

Reject 15% Accept

Reject 18% Reject

Accept 12% Accept

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 divisions 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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