Question

“I know headquarters wants us to add that new product line,” said Brian Stettler, manager of Sparks Products’ Central Division. “But I want to see the numbers before I make a move. Our division’s return on investment (ROI) has led the company for three years, and I don’t want any letdown.”

Sparks Products is a decentralized wholesaler with four autonomous divisions. The divisions are evaluated on the basis of ROI, with year-end bonuses given to divisional managers who have the highest ROI. Operating results for the company’s Central Division for last year are given below:

Sales	$	22,000,000
Variable expenses		14,000,000
Contribution margin		8,000,000
Fixed expenses		6,174,000
Net operating income	$	1,826,000
Divisional operating assets	$	5,500,000

The company had an overall ROI of 18% last year (considering all divisions). The company’s Central Division has an opportunity to add a new product line that would require an investment of $3,430,000. The cost and revenue characteristics of the new product line per year would be as follows:

Sales	$ 10,290,000
Variable expenses	65% of sales
Fixed expenses	$ 2,870,910

Required:
1.	Compute the Central Division’s ROI for last year; also compute the ROI as it would appear if the new product line is added. (Do not round intermediate percentage values. Round your final answers to 2 decimal places (i.e., 0.1234 should be entered as 12.34).)

2.	If you were in Brian Stettler’s position, would you accept or reject the new product line?
	Accept Reject

3.	Why do you suppose headquarters is anxious for the Central Division to add the new product line?
	Adding the new line would decrease the company's overall ROI. Adding the new line would increase the company's overall ROI.

4.	Suppose that the company’s minimum required rate of return on operating assets is 15% and that performance is evaluated using residual income.

a.	Compute the Central Division’s residual income for last year; also compute the residual income as it would appear if the new product line is added.

  

b.	Under these circumstances, if you were in Brian Stettler‘s position would you accept or reject the new product line?
	Accept Reject

References

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Answer 1

Net product line net operating income = 10290000*(1-65%)-2870910= $730590
Margin = Net operating income/Sales
Turnover = Sales/Operating assets
ROI = Margin*Turnover
	Present	New line	Total
Sales	22000000	10290000	32290000
Net operating income	1826000	730590	2556590
Operating assets	5500000	3430000	8930000
Margin	8.30%	7.10%	7.92%
Turnover	4.00	3.00	3.62
ROI	33.20%	21.30%	28.63%
1
ROI for this year = 33.20%
ROI for new product line alone = 21.30%
ROI for next year(Total) = 28.63%
2
Reject, as ROI decreases
3
Adding the new product line would increase company's overall ROI
4
	Present	New line	Total
Operating assets	5500000	3430000	8930000
Minimum required return	15%	15%	15%
Minimum Net operating income	825000	514500	1339500
Actual Net operating income	1826000	730590	2556590
Minimum Net operating income	825000	514500	1339500
Residual income	1001000	216090	1217090
a
Residual income for this year = $1001000
Residual income for new product line alone =$216090
Residual income for next year(Total) = $1217090
b
Accept, as residual income increases