Question

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Problem 10-18 Return on Investment (ROI) and Residual Income [LO10-1, LO10-2]

“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	$	10,000,000
Variable expenses		6,000,000
Contribution margin		4,000,000
Fixed expenses		3,200,000
Net operating income	$	800,000
Divisional average operating assets	$	4,000,000

The company had an overall return on investment (ROI) of 15% 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 $1,000,000. The cost and revenue characteristics of the new product line per year would be:

Sales	$2,000,000
Variable expenses	60% of sales
Fixed expenses	$640,000

Required:

1. Compute the Office Products Division’s ROI for this year.

2. Compute the Office Products Division’s ROI for the new product line by itself.

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

4. If you were in Dell Havasi’s position, would you accept or reject the new product line?

5. Why do you suppose headquarters is anxious for the Office Products Division to add the new product line?

6. Suppose that the company’s minimum required rate of return on operating assets is 12% 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 (2,000,000*40%)=					800,000
less Fixed expense					-640,000
Net operating income					160000
1,2&3)				present	new line	total
	Sales			10,000,000	2,000,000	12,000,000
	Net operating income			800,000	160,000	960,000
	operating assets			4,000,000	1,000,000	5,000,000
	margin			8.00%	8.00%	8.00%
	turnover			2.50	2.00	2.40
	ROI			20.00%	16.00%	19.20%
	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			4,000,000	1,000,000	5,000,000
	minimum required return			12%	12%	12%
	min net opeerating income			480000	120000	600000
	actual net operating income			800,000	160,000	960,000
	min net operating income			480000	120000	600000
	residual income			320,000	40,000	360,000
b)	Accept