Question

Refer to the following data regarding the three departments from Magenta:

	Bright Magenta	Standard Magenta	Dark Magenta
Total assets	$ 2,400,000	$ 1,000,000	$ 200,000
Total liability	$2,000,000	$ 800,000	$125,000
Revenues	$ 1,200,000	$ 1,000,000	$ 280,000
Operating profit	$ 240,000	$ 130,000	$ 35,000

The company uses a required rate of return of 12% for its departments. Management wants to evaluate the performance of its three departments for deciding which departmental manager is to be promoted.

Required

1. Which is the department with (i) the higher Return on Sales (ROS), (ii) the higher Return on Investment (ROI), and (iii) the higher Residual Income (RI)?

2. The board has set a target ROI of 20% for the Dark Magenta division. What alternatives does the department have for attaining this return?

Answer 1

ii. ROI = Operating income / total assets
	Bright Magneta	Standard Magneta	Dark Magneta
Operating income	240,000	130,000	35,000
total assets	2,400,000	1,000,000	200,000
ROI = Operating income / total assets	10.00%	13.00%	17.50%
1. Return on Sales = Operating income / Revenue
	Bright Magneta	Standard Magneta	Dark Magneta
Operating income	240,000	130,000	35,000
Revenue	1,200,000	1,000,000	280,000
Return on Sales	20.00%	13.00%	12.50%
iii. Residual income = Operating income - ( Required rate * total assets)
	Bright Magneta	Standard Magneta	Dark Magneta
Operating income (a)	240,000	130,000	35,000
Required rate (b)	12%	12%	12%
total assets (c )	2,400,000	1,000,000	200,000
Minimum Return Required (d=bXc)	288,000	120,000	24,000
Residual income (a-d)	-48,000	10,000	11,000

Curretnly ROI of Dark MAgneta is 17.50% which is very less as per target expected by board . TO meet the target , Operating Income of such division need to be increased by increaing revenue and optimising expenses.