1.

Encourages managers to pay attention to the relationships among sales, expenses, and
investment – Sales, expenses, and investment are three essential elements of the Return on
Investment or ROI. An increase in one element would affect the other. With this, since the goal
of the managers is to achieve a good ROI, it will lead them to always being mindful of the said
elements. They will always be keeping an eye on such elements, in order to achieve the desired
ROI. Their decision will always consider what would be the best or right amount of sales,
expenses, and investments so that its ROI will be attractive to the investors.

Encourages cost efficiency – The manager of an investment center always has the control over
the company’s costs. Therefore, increasing efficiency through a sensible reduction of costs is a
common method of increasing ROI. Encouraging cost efficiency means that non-value-added
costs must be reduced or productivity must be improved.

2. Residual income is a way of measuring financial efficiency and can be used to rate anything
that contributes in generating income. It tells the management if an alternative energy can help
them do better. There are instances that the residual income that computed turns out to be
negative even though a company’s investments help its money grow. A negative residual
income only means that the resources are poorly used and that with other approaches or other
alternative strategies, the firm could have done better. Negative residual income suggests that the
company is not profitable, which can make the company less interesting for the investors.
Residual income are sometimes being referred to as Economic Value Added (EVA), which is
why when the residual value is negative, it suggest that the company is not truly adding value
with what it is doing. Economic value added (EVA) is also a measure of the financial
performance of a company based on the residual wealth calculated by deducting its cost of
capital from its operating profit, adjusted for taxes on a cash basis. EVA can also be referred to
as economic profit since it attempts to capture the true economic profit of a company. If a
company's EVA is negative, it means that the funds that the company invested into the business
do not contribute value to the firm.

3. Transfer price is the prices charged for a component by the selling division to the buying
division of the same company. The process of transfer pricing is a complex issue which creates
an impact on the divisions, and the company as a whole. Transfer prices affect three managerial
accounting areas. First, transfer prices determine the costs and revenues among the transacting
divisions (buying and selling), affecting the performance evaluation of divisions. Second,
transfer prices affect division managers' incentives to sell goods either internally or externally. If
the transfer price is too low, the upstream division may refuse to sell its goods to the downstream
division, potentially impairing the company's profit-maximizing goal. Finally, transfer prices are
especially important when products are sold across international borders. The transfer prices
affect the company's tax liabilities if different jurisdictions have different tax rates.
4. ROI may influence a divisional manager to select only investments with high rates of return
(i.e., rates which are in line or above his target ROI). Other investments that would reduce the
division’s ROI but could increase the value of the business may be rejected by the divisional
manager. It is likely that another division may invest the available funds in a project that might
improve its existing ROI (which may be lower than a division’s ROI which has rejected the
investment) but which will not contribute as much to the enterprise as a whole.

These types of decisions are sub-optimal and can distort an enterprise’s overall allocation of
resources and can motivate a manager to make under investing in order to preserve its existing
ROI. A good or satisfactory return is defined as an ROI in excess of some minimum desired rate
of return, usually based on the firm’s cost of capital.

Business units having higher ROI and some other units having lower ROI are impacted
differently by using ROI as investment selection criteria, ROI evaluation provides disincentive to
the best division (having higher ROI) to grow, whereas the division with the lowest ROI will
have an incentive to invest in new projects to improve their ROI. In this situation, the most
profitable units are demotivated to invest in a project that does not exceed their current ROI,
although the project would give a good return. This may be in conflict with goal congruence and
interests of the firm as a whole.

5. RI is the dollar amount of division operating profit in excess of the division’s cost of acquiring
capital to purchase operating assets. Rather than using a ratio to evaluate performance, RI uses a
dollar amount. As long as an investment yields operating profit higher than the division’s cost of
acquiring capital, managers evaluated with RI have an incentive to accept the investment. The
manager’s goal is to increase RI from one period to the next. Since the manager’s goal is to
continually increase RI, using RI as a performance measure is an effective way to minimize the
conflict between company goals and division goals that arise using ROI. Rather than maximizing
ROI, division managers focus on increasing RI. Managers are more likely to accept investment
proposals that have a return greater than the company’s minimum required rate of return,
regardless of the impact on the division’s ROI.

6. Carla Klesko was given a bonus by the president because the Division Games' profit which
Carla manages resulted to a great increase and impressed him. The income statements of the
three divisions were reviewed by the president and when he compared the three, he ended up
being amazed by how the profit of Board Games division substantially increases for consecutive
years. Meanwhile, Larry disagrees that Carla deserves to be given a larger bonus than the other
division managers because in his opinion, the resources that were invested in the Board Games
division, compared to the others, should be considered. He believes that performance measures
such as return on investment, residual income and economic value added should also be
considered in assessing the profitability of the certain division. He knows that a greater amount
of profit is not enough to claim a division’s profitability because a large amount of profit doesn’t
always suggest a good profitability. There are instances when companies produce a positive net
income but have a negative economic value which indicates a poor use of resources. Larry insists
that the president should be using performance measures such as return on investment, residual
income, and economic value added in deciding what division really deserves a larger bonus.