Question

Selected sales and operating data for three divisions of different structural engineering firms are given as follows:

	Division A			Division B			Division C
Sales	$	12,120,000		$	28,120,000		$	20,120,000
Average operating assets	$	3,030,000		$	7,030,000		$	5,030,000
Net operating income	$	496,920		$	449,920		$	503,000
Minimum required rate of return		7.00	%		7.50	%		10.00	%

Required:

1. Compute the return on investment (ROI) for each division using the formula stated in terms of margin and turnover.

2. Compute the residual income (loss) for each division.

3. Assume that each division is presented with an investment opportunity that would yield a 8% rate of return.

a. If performance is being measured by ROI, which division or divisions will probably accept or reject the opportunity?

b. If performance is being measured by residual income, which division or divisions will probably accept or reject the opportunity?

Answer 1

Solution 1:

Profit Margin
Particulars	Choose Numerator		/	Choose denomerator		=	Profit Margin
	Details	Amount		Details	Amount
Division A	Operating Income	$496,920.00		Sales	$12,120,000.00		4.10%
Division B	Operating Income	$449,920.00		Sales	$28,120,000.00		1.60%
Division C	Operating Income	$503,000.00		Sales	$20,120,000.00		2.50%

Investment Turnover
Particulars	Choose Numerator		/	Choose denomerator		=	Investment Turnover
	Details	Amount		Details	Amount
Division A	Sales	$12,120,000.00		Average operating assets	$3,030,000.00		4.00
Division B	Sales	$28,120,000.00		Average operating assets	$7,030,000.00		4.00
Division C	Sales	$20,120,000.00		Average operating assets	$5,030,000.00		4.00

Return on Investment
Particulars	Profit Margin	*	Investment Turnover	=	Return on Investment
Division A	4.10%		4.00		16.40%
Division B	1.60%		4.00		6.40%
Division C	2.50%		4.00		10.00%

Solution 2:

Computation of Residual Income
Division	Operating Income	Minimum Required Return	Residual Income
Division A	$496,920.00	$212,100.00	$284,820.00
Division B	$449,920.00	$527,250.00	-$77,330.00
Division C	$503,000.00	$503,000.00	$0.00

Solution 3a:

If performance is being measure by ROI, then division having ROI less than 8% will probably accept the opportunity.

Therefore Division B will accept the investment opportunity and division A and C will reject the investment opportunity.

Solution 3b:

If performance is being measured by residual incoem, then division having minimum required return less than 8% will accept the investment opportunity.

Therefore Division A and Division B will accept the investment opportunity and Division C will reject the investment opportunity.