Question

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

Billings Company is a decentralized wholesaler with five autonomous divisions. The divisions are evaluated on the basis of ROI, with year-end bonuses given to the divisional managers who have the highest ROIs. Operating results for the company’s Office Products Division for this year are given below:

Sales	$	21,100,000
Variable expenses		13,350,400
Contribution margin		7,749,600
Fixed expenses		5,935,000
Net operating income	$	1,814,600
Divisional average operating assets	$	4,220,000

The company had an overall return on investment (ROI) of 18.00% this year (considering all divisions). Next year the Office Products Division has an opportunity to add a new product line that would require an additional investment that would increase average operating assets by $2,262,500. The cost and revenue characteristics of the new product line per year would be:

Sales	$9,050,000
Variable expenses	65% of sales
Fixed expenses	$2,534,000

Required

6. Suppose that the company’s minimum required rate of return on operating assets is 16% and that performance is evaluated using residual income.

a. Compute the Office Products Division’s residual income for this year.

b. Compute the Office Products Division’s residual income for the new product line by itself.

c. Compute the Office Products Division’s residual income for next year assuming that it performs the same as this year and adds the new product line.

d. Using the residual income approach, if you were in Dell Havasi’s position, would you accept or reject the new product line?

Answer 1

income on new line
contribution (9,050,000*35%)=					3,167,500
less Fixed expense					-2,534,000
Net operating income					633500
1,2&3)				present	new line	total
	Sales			21,100,000	9,050,000	30,150,000
	Net operating income			1,814,600	633,500	2,448,100
	operating assets			4,220,000	2,262,500	6,482,500
	margin			8.60%	7.00%	8.12%
	turnover			5.00	4.00	4.65
	ROI			43.00%	28.00%	37.76%
	where margin = net operating income/sales
	turnover = sale/average operating assets
	ROI = margin *turnover
4)	Reject
5)	Addint the new product line would improve overall ROI
6)	Residual income = net operating income -(average assets *min rate or return)
				present	new line	total
	operating assets			4,220,000	2,262,500	6,482,500
	minimum required return			16%	16%	16%
	min net opeerating income			675200	362000	1037200
	actual net operating income			1,814,600	633,500	2,448,100
	min net operating income			675200	362000	1037200
	residual income			1,139,400	271,500	1,410,900
b)	Accept