Familia and Homelia, two divisions of Greenfood Company, reported the following results from last years operations:

Familia Homelia

Sales.............................. $16,100,000 $3,100,000

Variable expenses......... 10,400,000 1,950,000

Contribution margin ..... 5,700,000 1,150,000

Fixed expenses ............. 4,734,000 960,000

Net operating income ... $ 966,000 $ 190,000

Average operating assets $6,000,000 $1,000,000

Greenfood Company has traditionally evaluated all of its divisions based on the return on investment (ROI). The companys minimum required rate of return is 13%. The management team of any division reporting an annual increase in the ROI is automatically eligible for a bonus. The management of divisions reporting a decline in the ROI must provide convincing explanations for the decline to be eligible for a bonus. Moreover, this bonus is limited to 50% of the bonus paid to divisions reporting an increase in ROI.

At the beginning of this year, Familia has a $1,300,000 investment opportunity with the following characteristics: Sales: $3,840,000. Contribution margin ratio 50% of sales Fixed expenses: $1,728,000

Greenfood Companys top management has strongly urged Linda Smith, division manager of Familia to consider this new investment opportunity. Linda has reviewed Familias financial statements and the new investment opportunity with her controller, Tony Johnson. They believe the investment opportunity may not be in the best interest of Familia. If we decide not to do this, the Greenfood people are not going to be happy, said Linda. If we could convince them to base our bonuses on something other than ROI, maybe this investment opportunity would look more attractive. How would we do if the bonuses were based on residual income? Our friends in Homelia may not like it, though, Tony said.

a) If Greenfood Company continues to use ROI as the sole measure of divisional performance, explain why Familia would be reluctant to pursue the new investment opportunity? Show detailed computation to support your answer.

b) If Greenfood Company could be persuaded to use residual income to measure the performance of Familia, explain why Familia would be more willing to pursue the new investment opportunity? Show detailed computation to support your answer.

c) Explain the disadvantage of using residual income to evaluate divisional performance. Be specific to Greenfood Companys situation and show detailed computation to support your answer.