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	$	21,810,000
Variable expenses		13,741,200
Contribution margin		8,068,800
Fixed expenses		6,040,000
Net operating income	$	2,028,800
Divisional average operating assets	$	4,363,000

The company had an overall return on investment (ROI) of 18.00% 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 $2,350,000. The cost and revenue characteristics of the new product line per year would be:

Sales	$9,396,500
Variable expenses	65% of sales
Fixed expenses	$2,564,875

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 15% 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. ROI this year = 2028800 / 4363000 = 46.50%

2. ROI for the new product line itself= (9396500*0.35-2564875) / 2350000 = 30.80%

3. ROI for the next year = (2028800 + 723900) / (4363000 + 2350000) = 2752700 / 6713000 = 41.01%

4. I would reject the investment oppurtunity, because after adding the new product line, the divisions overall ROI is decresed, which affects the bonus. But, considering this if management changes the bonus plan, it is beneficial to the company accepting this investment because, the ROI is more than the companys average ROI.

5. Head Quarters would be anxious of adding the product line, because the ROI from this product line is more than the companys average ROI.

6.

a. Residual Income for this year = 2028800 - 4363000*15% = $ 1374350

b. Residual Income for the new product line itself = 723900 - 2350000*15% = $ 371400

c. Residual Income for the next Year = 2752700 - 6713000*15% = $ 1745750

d. Accept, provided the bonus plan is based on the highest residual income rather than the Highest ROI.