Question

Selected sales and operating data for three divisions of different structural engineering firms are given as follows:

	Division A			Division B			Division C
Sales	$	12,440,000		$	35,550,000		$	25,550,000
Average operating assets	$	3,110,000		$	7,110,000		$	5,110,000
Net operating income	$	547,360		$	639,900		$	740,950
Minimum required rate of return		10.00	%		10.50	%		14.50	%

Required:

1. Compute the return on investment (ROI) for each division using the formula stated in terms of margin and turnover.

2. Compute the residual income (loss) for each division.

3. Assume that each division is presented with an investment opportunity that would yield a 11% rate of return.

a. If performance is being measured by ROI, which division or divisions will probably accept or reject the opportunity?

b. If performance is being measured by residual income, which division or divisions will probably accept or reject the opportunity?

Answer 1

Answer-1)-Division A- Margin – (Net operating income /Sales)*100

= ($547360/$12440000)*100

= 4.4%

Turnover = Sales/ Average operating assets

= $12440000/$3110000

= 4

Return on investment = Margin*Turnover

= 4.4%*4

= 17.6%

Division B- Margin – (Net operating income /Sales)*100

= ($639900/$35550000)*100

= 1.8%

Turnover = Sales/ Average operating assets

= $35550000/$7110000

= 5

Return on investment = Margin*Turnover

= 1.8%*5

=9%

Division C- Margin – (Net operating income /Sales)*100

= ($740950/$25550000)*100

= 2.9%

Turnover = Sales/ Average operating assets

= $25550000/$5110000

= 5

Return on investment = Margin*Turnover

= 2.9%*5

= 14.5%

2)- Residual income =Operating income –(Average operating assets*Required rate of return)

Division A= $547360-($3110000*10%)

= $547360-$311000

= $236360

Division B= $639900-($7110000*10.50%)

= $639900-$746550

= $(106650)

Division C= $740950-($5110000*14.50%)

= $740950-$740950

= 0

3)-a)- If performance is being measured by ROI, both Division A and Division C probably would reject the 11% investment opportunity. These divisions’ ROIs currently exceed 11%; accepting a new investment with a 11% rate of return would reduce their overall ROIs. Division B probably would accept the 11% investment opportunity because accepting it would increase the division’s overall rate of return.

b)- If performance is being measured by residual income, division A & B will probably accept and division C reject the opportunity.