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	$	22,505,000
Variable expenses		14,105,500
Contribution margin		8,399,500
Fixed expenses		6,145,000
Net operating income	$	2,254,500
Divisional average operating assets	$	4,687,500

The company had an overall return on investment (ROI) of 17.00% 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 $3,261,000. The cost and revenue characteristics of the new product line per year would be:

Sales	$9,750,000
Variable expenses	65% of sales
Fixed expenses	$2,595,300

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 14% 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

5. Why do you suppose headquarters is anxious for the Office Products Division to add the new product line?

ROI= Net operating income/Average operating assets

Current

ROI= $2254500*100/4687500= 48.10%

Net operating profit under New product line= $9750000*35%-2595300= $817200

New product line

ROI= $817200*100/3261000= 25.06%

Current with the new product line

New operating income= $2254500+817200= $3071700

New average operating assets= $4687500+3261000= $7948500

ROI= $3071700*100/7948500= 38.65%

Headquarters is anxious for adding the new product line because the overall ROI of the company will increases when the new product line is added.

6. Suppose that the company’s minimum required rate of return on operating assets is 14% and that performance is evaluated using residual income.

a. Compute the Office Products Division’s residual income for this year.

Residual income= Net operating income-(Average operating assets*Minimum required rate of return)

= $2254500-(4687500*14%)= $1598250

b. Compute the Office Products Division’s residual income for the new product line by itself.

Residual income= Net operating income-(Average operating assets*Minimum required rate of return)

= $817200-(3261000*14%)= $360660

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.

Residual income= Net operating income-(Average operating assets*Minimum required rate of return)

= $3071700-(7948500*14%)= $1958910

d. Using the residual income approach, if you were in Dell Havasi’s position, would you accept or reject the new product line?

Yes, accept the new product line because the residual income of the company will increases if the new product line is added.