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	$	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

1. DIVISIONAL NET OPERATING INCOME=$800000

DIVISIONAL OPERATING ASSETS =$4000000

ROI OF DIVISION=OPERATING INCOME/OPERATING ASSETS*100

=80000/400000*100=20%  

2. NEW PRODUCT LINE

SALES =2000000

VARIABLE EXPENSES =1200000

CONTRIBUTION =800000

FIXED EXPENSES =640000

OPERATING PROFIT =$160000

OPERATING ASSETS =$1000000

ROI OF PRODUCT LINE =OPERATING INCOME/OPERATING ASSETS*100

=160000/1000000*100=16%

3.NEXT YEAR PROFIT=OLD PROFIT+NEW PROFIT

   =800000+160000=$960000

NEXT YEAR ASSETS=4000000+1000000=$5000000

ROI OF NEXT YEAR =OPERATING INCOME/OPERATING ASSETS*100

=960000/5000000=19.2%

4. I WILL REJECT THE OFFER AS NEW PRODUCT ROI IS LESS THAN DIVISIONAL ROI OF 20%

5. HEADQUARTER IS ANXIOUS TO ADD NEW PRODUCT AS NEW PRODUCT ROI IS MORE THAN 15% ROI OF OVERALL COMPANY.

6. RESIDUAL INCOME= OPERATING PROFIT-(ASSETS*REQUIRED RATE OF RETURN)

A. RESIDUAL ICOME=800000-(4000000*.12)=$320000

B. RESIDUAL ICOME=160000-(1000000*.12)=$40000

C. RESIDUAL ICOME=960000-(5000000*.12)=$360000

D. I WOULD ACCEPT THIS OFFER AS RESIDUAL INCOME IS IN POSITIVE.