Question

The contribution format income statement for Huerra Company for last year is given below:

	Total		Unit
Sales	$	998,000	$	49.90
Variable expenses		598,800		29.94
Contribution margin		399,200		19.96
Fixed expenses		321,200		16.06
Net operating income		78,000		3.90
Income taxes @ 40%		31,200		1.56
Net income	$	46,800	$	2.34

The company had average operating assets of $493,000 during the year.

Required:

1. Compute the company’s return on investment (ROI) for the period using the ROI formula stated in terms of margin and turnover.

For each of the following questions, indicate whether the margin and turnover will increase, decrease, or remain unchanged as a result of the events described, and then compute the new ROI figure. Consider each question separately, starting in each case from the data used to compute the original ROI in (1) above.

2. Using Lean Production, the company is able to reduce the average level of inventory by $96,000. (The released funds are used to pay off short-term creditors.)

3. The company achieves a cost savings of $12,000 per year by using less costly materials.

Answer 1

Solution

Huerra Company

1. Computation of ROI:

ROI = margin x turnover
margin = net operating income/sales

Net operating income = $78,000

Sales = $998,000

Margin = (78,000/998,000) x 100 = 7.82%

Turnover = sales/average operating assets

Average operating assets = $493,000

Turnover = 998,000/493,000 = 2.02

ROI = 7.82% x 2.02 = 15.83%

1. Computation of ROI when inventory reduced by $96,000:

When Inventory reduces, average operating assets reduce by $96,000.

Hence, average operating assets = 493,000 – 96,000 = $397,000

Margin remains unchanged at 7.82%, as the figures of net operating income and sales remain unchanged.

Turnover = 998,000/397,000 = 2.51

Hence, Turnover increases when operating assets reduce.

ROI = 7.82% x 2.51 = 19.66%

Hence, ROI Increases when average operating assets reduce.

1. Computation of ROI when Cost savings of $12,000:

Cost savings of $12,000 indicates increase in operating income by $12,000

Hence operating income = 78,000 + 12,000 = $90,000

Margin = (90,000/998,000) x 100 = 9.02%

Hence, margin increases with cost savings of $12,000.

Turnover remains unchanged at 2.02 since no change in average operating assets and sales values.

ROI = 9.02% x 2.02 = 18.23%

Hence, ROI increases with cost savings of $12,000.