Question

The contribution format income statement for Huerra Company for last year is given below:

	Total		Unit
Sales	$	996,000	$	49.80
Variable expenses		597,600		29.88
Contribution margin		398,400		19.92
Fixed expenses		316,400		15.82
Net operating income		82,000		4.10
Income taxes @ 40%		32,800		1.64
Net income	$	49,200	$	2.46

The company had average operating assets of $493,000 during the year.

Required:

1. Compute the company’s return on investment (ROI) for the period using the ROI formula stated in terms of margin and turnover.

Margin 4.94 % Turnover 197.62 ROI 9.76 %

For each of the following questions, indicate whether the margin and turnover will increase, decrease, or remain unchanged as a result of the events described, and then compute the new ROI figure. Consider each question separately, starting in each case from the data used to compute the original ROI in (1) above.

2. Using Lean Production, the company is able to reduce the average level of inventory by $91,000. (The released funds are used to pay off short-term creditors.)

	Effect Margin 4.94 % Unchanged Turnover 244.72 Increase ROI 12.09 % Increase

3. The company achieves a cost savings of $11,000 per year by using less costly materials.

	Effect Margin 6.24 % Increase Turnover 197.62 Decrease ROI 12.34 % Increase

3a. The company issues bonds and uses the proceeds to purchase machinery and equipment that increases average operating assets by $126,000. Interest on the bonds is $14,000 per year. Sales remain unchanged. The new, more efficient equipment reduces production costs by $4,000 per year.

	Effect Margin 8.94 % Increase Turnover 1.58 Decrease ROI 14.15 % Decrease

Answer 1

1.
Margin for the period is
Margin     =	Net operating income
	Sales
=	$82000
	$996000
=	8.2329%
Turnover for the period is
Turnover =	Sales
	Average operating assets
=	$996000
	$493000
=	2.020284
ROI for the period is
ROI             =	Margin X Turnover
=	8.2329% X 2.020284
=	16.6328%
Margin	8.2329%
Turnover	2.020284
ROI	16.6328%

2. Average level of inventory is reduced by $91,000 reduces the average operating asset
Average operating assets      =			$493000-$91000
		=	$402000
There is no change in margin. New turnover is
Turnover =	Sales
	Average operating assets
=	$996000
	$402000
=	2.477612
ROI for the period is
ROI             =	Margin X Turnover
=	8.2329% X 2.477612
=	20.3979%
Margin	8.2329%	Unchanged
Turnover	2.477612	Increase
ROI	20.3979%	Increase

3. There is cost savings of $11,000 which means there is increase in net operating income
Net operating income =			$82,000 +$11,000
		=	$93000
New margin is
Margin     =	Net operating income
	Sales
=	$93000
	$996000
=	9.3373%
Turnover remains same.
New ROI is
ROI             =	Margin X Turnover
=	9.3373% X 2.020284
=	18.8640%
Margin	9.3373%	Increase
Turnover	2.020284	Unchanged
ROI	18.8640%	Increase

3a. Purchase of machinery and equipment increases the average operating assets by $126,000. Interest on bonds decreases the net income by $14,000 and the reduction in production cost increases the net operating income by $4,000.
Average operating assets             =			$493000+$126000
		=	$619000
Now
Net operating income              =			$82000+$4000
		=	$86000
Now
Particulars		Amount
Net operating income		$82000
Less: Interest expense		$14000
Net income before taxes		$68000
Less: Income taxes		$32800
Net income		$35200
New margin is
Margin     =	Net operating income
	Sales
=	$86000
	$996000
=	8.6345%
New turnover is
Turnover =	Sales
	Average operating assets
=	$996000
	$619000
=	1.60904685
New ROI is
ROI             =	Margin X Turnover
=	8.6345% X 1.60904685
=	13.8933%
Margin	8.6345%	Increase
Turnover	1.60904685	Decrease
ROI	13.8933%	Decrease