Question

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

	Total		Unit
Sales	$	1,000,000	$	50.00
Variable expenses		600,000		30.00
Contribution margin		400,000		20.00
Fixed expenses		322,000		16.10
Net operating income		78,000		3.90
Income taxes @ 40%		31,200		1.56
Net income	$	46,800	$	2.34

The company had average operating assets of $491,000 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 $109,000. (The released funds are used to pay off short-term creditors.)

3. The company achieves a cost savings of $11,000 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 $122,000. Interest on the bonds is $18,000 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 $20,000 is scrapped and written off as a loss.

7. At the beginning of the year, the company uses $177,000 of cash (received on accounts receivable) to repurchase and retire some of its common stock.

Answer 1

Solution:

Note 1. Operating Assets turnover ratio = Sales/average operating assets

Note 2. Margin = (Net income/sales)*100

Note 3. ROI(Return on Investment)= (Net income/Ttal operating assets)*100

Note 4. Operating Assets = $4,91,000

1. Operating Assets turnover ratio ($10,00,000/$4,91,000) = 2.04

Margin ($46,800/$10,00,000)*100 = 4.68%

ROI ($46,800/$4,91,000)*100 = 9.53%

2. Reduction in average inventory will reduce total opearting assets.

Total opearting assets ($4,91,000-$1,09,000) = $3,82,000

Operating Assets turnover ratio ($10,00,000/$3,82,000) = 2.62

Margin ($46,800/$10,00,000)*100 = 4.68%

ROI ($46,800/$3,82,000)*100 = 12.25%

3. Saving in cost will increase net income by $(46,800+$11,000) = $57,800

Operating Assets turnover ratio ($10,00,000/$4,91,000) = 2.04

Margin ($57,800/$10,00,000)*100 = 5.78%

ROI ($ 57,800/$4,91,000)*100 = 11.77%

4. Operating assets increase by ($4,91,000+$122,000) = $6,13,000

Saving in production cost pf $5000 will increase net income by ($46,800+5,000) = $51,800

Operating Assets turnover ratio ($10,00,000/$6,13,000) = 1.63

Margin ($51,800/$10,00,000)*100 = 5.18%

ROI ($51,800/$6,13,000)*100 = 8.45%

5. Sales increase by 10% is given in question.

So, No. of units at present ($10,00,000/$50,000) = 20,000unit

No. of units after 10% increase ($11,00,000/$50,000) = 22,000unit

Particular	Per unit($)	Value at 20,000 unit($)	Value at 22,000 unit($)
Sales	50	10,00,000	11,00,000
Variable expense	30	6,00,000	6,60,000
Contribution margin	20	4,00,000	4,40,000
Fixed expense	16.10	3,22,000	5,18,000
Net operating income	3.90	78,000	85,800
Income tax@ 40%	1.56	31,200	34,320
Net Income	2.34	46,800	51,480

Operating Assets turnover ratio ($11,00,000/$4,91,000) = 2.24

Margin ($51,480/11,00,000)*100 = 4.68%

ROI ($51,480/11,00,000)*100 = 10.48%

6. Obsolete inventory reduces by 20,000 will affect both Net income & operating Assets.

So, Net income($46,800-$20,000) = $26,800

Operating assets ($4,91,000-$20,000) = $4,71,000

Operating Assets turnover ratio ($10,00,000/$4,71,000) = 2.12

Margin ($26,800/$10,00,000)*100 = 2.68%

ROI ($26,800/$4,71,000)*100 = 5.69%

7. Operating assets decrease by $177,000 for using of cash by company.

So, operating assets ($4,91,000-$1,77,000) = $3,14,000

Operating Assets turnover ratio ($10,00,000/$3,14,000) = 3.18

Margin ($46,800/$10,00,000)*100 = 4.68%

ROI ($46,800/$3,14,000)*100 = 14.90%