Question

Small Appliances Division Cleaning Products Division

Sales $34,670,000 $31,320,000

Operating income 2,773,600 1,252,800

Operating assets, January 1 6,394,000 5,600,000

Operating assets, December 31 7,474,000 6,000,000

Forchen, Inc., requires an 8 percent minimum rate of return.

For the Small Appliances Division, calculate:

a. Average operating assets

b. Margin

c. Turnover

d. Return on investment (ROI)

2. For the Cleaning Products Division, calculate:

a. Average operating assets

b. Margin

c. Turnover

d. Return on investment (ROI)

3. What if the minimum required rate of return was 9 percent? How would that affect the residual income of the two divisions?

Answer 1

Part 1

For the Small Appliances Division:

a. Average Operating Assets = (Beginning Assets + Ending Assets)/2 = (6394000+7474000) / 2 = $6934000

b. Margin = operating income / sales = 2773600/34670000 = 0.08 = 8%

c. Turnover = sales / average operating assets = 34670000/6934000 = 5

d. ROI = Margin * Turnover = 0.08* 5 = 0.40 = 40%

Part 2

For the Cleaning Products Division

a. Average Operating Assets = (Beginning Assets + Ending Assets)/2 = (5600000+6000000) / 2 = $5800000

b. Margin = operating income / sales = 1252800/31320000 = 0.04 = 4%

c. Turnover = sales / average operating assets = 31320000/5800000 = 5.4

d. ROI = Margin * Turnover = 0.04* 5.4 = 0.216 = 21.60%

Part 3

Residual income before change in minimum required rate of return i.e. 8%

Residual Income = Operating Income - (Minimum rate of return x Operating assets)

Small Division = 2,773,600 - ( 0.08 x 6,934,000 ) = 2,218,880

Cleaning Division = 1,252,800 - ( 0.08 x 5,800,000 ) = 788,800

Residual income after change in minimum required rate of return i.e. 9%

Small Division 2,773,600 - ( 0.09 x 6,934,000 ) = 2,149,540

Cleaning Division 1,252,800 - ( 0.09 x 5,800,000 ) = 730,800

This shows that with increase in minimum required rate of return, there is decrease in residual income.