Answer to Question #127116 in Accounting for Relebogile

Question

Explain the marits and problems of using the return on investments, residual income and economic value added methods.

Answer 1

The merits of using the rate of return on investments because it is a better measure of profitability, and performance of investment division, however it is difficult to satisfactory define the rate of return on investments as it has many concepts such as profit before interest and tax, profit after interest and tax, controllable profit, profit after deducting all allocated fixed costs and the term investment may have many connotations such as gross book value, net book value, historical cost of assets, and current cost of assets, assets including or excluding intangible assets.

The advantages of residue income managers can spread the risk by assembling new investments. By taking into account the opportunity cost of tying up assets in the division, ease of use of different assets to earn different returns and the effect of maximizing dollars rather than a percentage. Disadvantages of residue income, it is difficult to contrast performance across units. Residual Income increases as investment and cost decreases, so the managers cut research and development costs and employee training costs for higher Residual Income.

The advantages of economic value added it complements financial data in business valuation and assessment; it shows the cost management of businesses and illustrates working capital availability after the deduction of its actual opportunity cost. It is used as a management incentive to ensure a company’s continuity of operations, besides overcoming problems related to percentage calculations by making use of specific values. Disadvantages it cannot determine how effectively capital asset holders utilize the retained profits and cannot calculate the return on expenses like research and development.