Question

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

	Total		Unit
Sales	$	1,008,000	$	50.40
Variable expenses		604,800		30.24
Contribution margin		403,200		20.16
Fixed expenses		327,200		16.36
Net operating income		76,000		3.80
Income taxes @ 40%		30,400		1.52
Net income	$	45,600	$	2.28

The company had average operating assets of $504,000 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 $99,000. (The released funds are used to pay off short-term creditors.)

3. The company achieves a cost savings of $14,000 per year by using less costly materials.

4. The company issues bonds and uses the proceeds to purchase machinery and equipment that increases average operating assets by $127,000. Interest on the bonds is $10,000 per year. Sales remain unchanged. The new, more efficient equipment reduces production costs by $5,000 per year.

5. As a result of a more intense effort by sales people, sales are increased by 10%; operating assets remain unchanged.

6. At the beginning of the year, obsolete inventory carried on the books at a cost of $19,000 is scrapped and written off as a loss.

7. At the beginning of the year, the company uses $181,000 of cash (received on accounts receivable) to repurchase and retire some of its common stock.

Answer 1

SOLUTION:-

Answer to Part 5.

Margin = Net Operating Income/ Sales * 100

Expected Net Operating Income = Expected Contribution Margin - Fixed Expenses

Expected Contribution Margin = 403,200 * 1.25

Expected Contribution Margin = $504,000

Expected Net Operating Income = $504,000 - $327,200

Expected Net operating Income = $176,800

Expected Sales = $1,008,000 * 1.25 = $1,260,000

Margin = 176,800 / 1,260,000 * 100

Margin = 14.03% (Increase)

Turnover = Sales/ Average Operating Assets

Turnover = 1,260,000 / 504,000

Turnover = 2.5 times (Increase)

ROI = Margin * Turnover

ROI = 14.03% * 2.5

ROI = 35.08% (Decrease)

Answer to part 6.

Writing off scrapped Inventory will decrease Average Operating Assets.

Expected Operating Assets = $504,000 - $18,000 = $486,000

Margin = Net Operating Income/ Sales * 100

Margin = 76,000 / 1,008,000 * 100

Margin = 7.54% (No Effect)

Turnover = Sales/ Average Operating Assets.

Turnover = 1,008,000 / 486,000

Turnover = 2.07 times (Increase)

ROI = Margin * Turnover

ROI = 7.54% * 2.07

ROI = 15.61% (Increase)

Answer to Part 6.

Use of Cash to repurchase Common Stock will decrease Average Operating Assets.

Expected Operating Assets = $504,000 - $179,000 = $325,000

Margin = Net Operating Income/ Sales * 100

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