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	$	12,000,000		$	14,000,000		$	25,000,000
Average operating assets	$	3,000,000		$	7,000,000		$	5,000,000
Net operating income	$	600,000		$	560,000		$	800,000
Minimum required rate of return		14	%		10	%		16	%

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 15% 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

1. ROI = Margin x Turnover
Margin = Net Operating Income / Sales
Turnover = Sales / Average Operating Assets

Division A
ROI = 5% x 4 = 20%
Margin = $600000 / 12000000 = 5%
Turnover = $12000000 / 3000000 = 4 times

Division B
ROI = 4% x 2 = 8%
Margin = $560000 / 14000000 = 4%
Turnover = $14000000 / 7000000 = 2 times

Division C
ROI = 3.2% x 5 = 16%
Margin = $800000 / 25000000 = 3.2%
Turnover = $25000000 / 5000000 = 5 times

2. Residual Income = Net Operating Income - Average Operating Assets x Minimum required rate of return
Division A = $600000 - 3000000 x 14% = $180000
Division B = $560000 - 7000000 x 10% = ($140000)
Division C = $800000 - 5000000 x 16% = 0

3.
a. Based on ROI, Division B will accept the opportunity since its divisions current ROI is less than yield of new investment opportunity.
But Division A and C will reject the opportunity, since they have higher ROI

b. Based on Residual Income, Division A and B will accept the opportunity, since yield of new opportunity is higher than minimum required return.
But Division C will reject the opportunity.