Final answer:
Residual income is used to evaluate the performance of an investment center within a company since it measures net operating income above the minimum return on its assets. It is not as applicable for cost centers, profit centers, or revenue centers. This metric helps decide if an investment center like a Yoga Center should continue or cease operations based on rental contract terms, revenue, and costs.
Step-by-step explanation:
The concept of residual income is often used to evaluate the performance of an investment center, which is one of several types of responsibility centers within a company. Residual income is particularly useful for investment centers because it measures the net operating income generated by the center above the minimum required return on its operating assets. This performance metric is less commonly applied to cost centers, profit centers, or revenue centers, as these do not have comparable investment responsibilities typically associated with an investment center.
For instance, if a Yoga Center (serving as an investment center) earns revenues of $20,000 and variable costs are $15,000, the center is generating sufficient revenue to cover its variable costs and should continue in business in the short run. However, a Yoga Center with revenues of $10,000 and variable costs of $15,000 is not covering its variable costs and should shut down immediately to avoid incurring additional losses.