Residual IIncome Case Study

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ii. Residual IncomeI (RI) The concept of rResidual iIncome (RI) is was developed by the General Electric Company of USA as an alternative tool to evaluate performance of an investment centre. The approach aims to maximize residual income. RI is the amount of a division’s net operating income whichincome that is arrived at after deducting the capital charges on the assets used by the division. In other words, it is the income which is remainsing after deducting provisions of expected return on investmentROI. RI = Profit – Capital cCharge or RI = Profit – (rRequired rate of return on X investment) Capital charge is the interest that is foregone as the funds are tied up in the business. i.eI. it is the opportunity cost of an investment made…show more content…
` 80,00,000 and the cost of capital is 16%. Calculate the ROI and RI. Solution: ROI = (10,00,000/ 80,00,000) X 100 = 12.5% RI = Profit – Ccapital charge = Rs. `10,00,000 – Rs.` (80,00,000 X 16%) = `Rs. 10,00,000 – Rs. `12,80,000 = Rs. ` 2,80,000 (negative) The profit centre is not performing well. The ROI given by the centre is less than the expected ROI. Residual income is negative, as the cost of capital (Rs. `12,80,000) is more than the profit earned. The pPerformance of a profit centre needs improvement. iii. EVAEconomic Value Added (EVA) Economic value added (EVA) is an improvement over the RI. It is the a trademark tool created by Stern Stewart & Company, a management consulting firm. It is calculated as follows: Economic value added = Net operating profits after taxes – (percent cost of capital X aAverage operating assets) or After-tax operating income – [cCost of capital x (total assets – current…show more content…
`400 lakhs – [12% X (800 lakhsl – 250 lakhsl)] = Rs. `334 lakhs. 2.1.4 Managerial Implications Besides evaluating the performance of the organisation, Ffollowing are as well, the effects implications of having a good responsibility accounting system at an organisation: • It helps to establish a sound system of control. The authority is delegated to each responsibility centres and the overall control is retained at the top management. • It enables decentralised decision making. It thus helps in placement of responsibility and tracking the unfavourable results. • Budget is easily set in an organisation with a responsibility accounting system in place. It encourages comparison of results with the budgeted performances. • It instils a sense of responsibility in the human resource as they are made responsible for the adverse deviations in their performance. • Reports are made simple ignoring the items which falls beyond the scope of responsibility. Thus it facilitates prompt reporting. • Management by Exception is followed by reducing the burden of the top management in considering all the activities. Instead the activities that are required attention are taken in to consideration. Self-assessment

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