Question

Problem 10-20 Return on Investment (ROI) Analysis [LO10-1]

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

	Total		Unit
Sales	$	1,006,000	$	50.30
Variable expenses		603,600		30.18
Contribution margin		402,400		20.12
Fixed expenses		326,400		16.32
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 $506,000 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 $98,000. (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 $125,000. Interest on the bonds is $12,000 per year. Sales remain unchanged. The new, more efficient equipment reduces production costs by $4,000 per year.

5. As a result of a more intense effort by salespeople, sales are increased by 20%; operating assets remain unchanged.

6. At the beginning of the year, obsolete inventory carried on the books at a cost of $18,000 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

Huerra Company

1. Computation of ROI:

ROI = margin x turnover
margin = net operating income/sales

Net operating income = $76,000

Sales = $1,006,000

Margin = (76,000/1,006,000) x 100 = 7.55%

Turnover = sales/average operating assets

Average operating assets = $506,000

Turnover = 1,006,000/506,000 = 1.99 times

ROI = 7.55% x 1.99 = 15%

Margin	7.55%
Turnover	1.99
ROI	15%

2. Computation of ROI when inventory reduced by $98,000:

	Original	Revised	Effect
Margin	7.55%	7.55%	No Effect
Turnover	1.99	2.47	Increase
ROI	15%	18.62%	Increase

When Inventory reduces, average operating assets reduce by $98,000.

Hence, average operating assets = 506,000 – 98,000 = $408,000

Margin remains unchanged at 7.55%, as the figures of net operating income and sales remain unchanged.

Turnover = 1,006,000/408,000 = 2.47

Hence, Turnover increases when operating assets reduce.

ROI = 7.55% x 2.47 = 18.62%

Hence, ROI Increases when average operating assets reduce.

3. Computation of ROI when Cost savings of $14,000:

	Original	Revised	Effect
Margin	7.55%	8.95%	Increase
Turnover	1.99	1.99	No Effect
ROI	15%	17.80%	Increase

Cost savings of $14,000 indicates increase in operating income by $14,000

Hence operating income = 76,000 + 14,000 = $90,000

Margin = (90,000/1,006,000) x 100 = 8.95%

Hence, margin increases with cost savings of $14,000.

Turnover remains unchanged at 1.99 since no change in average operating assets and sales values.

ROI =8.95% x 1.99 = 17.80%

Hence, ROI increases with cost savings of $14,000.

4. Increase in operating assets by $125,000; interest expense $12,000; and cost reduction by $4,000;

	Original	Revised	Effect
Margin	7.55%	7.95%	Increase
Turnover	1.99	1.59	Decrease
ROI	15%	12.64%	Decrease

Revised average operating assets = 506,000 + 125,000 = $631,000

Revised net operating income = 76,000 + cost reduction of $4,000 = $80,000

Sales remain unchanged

Interest expense is not relevant for computation of net operating income.

Revised

Margin = (80,000/1,006,000) x 100 = 7.95%

Turnover = 1,006,000/631,000 = 1.59

ROI = 7.95% x 1.59 = 12.64%

5. Increase in sales by 20%:

	Original	Revised	Effect
Margin	7.55%	12.96%	Increase
Turnover	1.99	2.39	Increase
ROI	15%	30.97%	Increase

Sales = 1,006,000 + 20% x 1,006,000 = $1,207,200

Contribution margin ratio (original) = 402,400/1006,000 = 40%

Revised contribution margin = 1,207,200 x 40% = $482,880

Less: fixed expenses = $326,400

Net operating income = $156,480

Margin = 156,480/1,207,200 = 12.96%

Turnover= 1,207,200/506,000 = 2.39

ROI = 12.96% x 2.39 = 30.97%

6. Obsolete inventory written off as loss $18,000

	Original	Revised	Effect
Margin	7.55%	5.76%	Decrease
Turnover	1.99	2.06	Increase
ROI	15%	11.87%	Decrease

Net operating income decrease by $18,000

= 76,000 – 18,000 = $58,000

Average operating assets decrease by $18,000

506,000 – 18,000 = $488,000

Margin = 58,000/1,006,000 = 5.76%

Turnover = 1,006,000/488,000 = 2.06

ROI = 5.76% x 2.06 = 11.87%

7. The use of cash to the extent of $181,000 for repurchase of stock has no effect on average operating assets and on operating income. Hence,

	Original	Revised	Effect
Margin	7.55%	7.55%	No Effect
Turnover	1.99	1.99	No Effect
ROI	15%	15%	No Effect