Back Mountain Industries (BMI) has two divisions: East and West. BMI has a cost of capital of 25 percent. Selected financial information (in thousands of dollars) for the first year of business follows.

East West

Sales revenue $1,400 $5,400

Income 270 450

Investment (beginning of year) 1,900 2,400

Current liabilities (beginning of year) 220 220

R&D expenditures (note a) 500 400

A R&D is assumed to benefit two periods. All R&D is spent at the beginning of the year.

Required:

Evaluate the performance of the two divisions assuming BMI uses residual income.

Both divisions have negative residual income, but the performance of West Division is preferred

Explanation:

Residual income is the word used in describing the remnant of profit after cost of doing business (cost of capital) has been deducted from net income.

The formula is stated thus:

residual income=net income - (cost of capital*investment)

For East Division, residual income is computed as follows:

Net income is $270,000

Investment is $1,900,000

cost of capital is 25%

residual income=$270,000 - ($1,900,000*25%) = -$205,000

For West Division, residual income is computed as follows:

Net income is $450,000

Investment is $2,400,000

cost of capital is 25%

residual income=$450,000 - ($2,400,000*25%) = -$150000