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 $ 21,750,000 Variable expenses 13,731,600 Contribution margin 8,018,400 Fixed expenses 6,025,000 Net operating income $ 1,993,400 Divisional average operating assets $ 4,338,800 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 $2,126,350. The cost and revenue characteristics of the new product line per year would be: Sales $9,350,000 Variable expenses 65% of sales Fixed expenses $2,560,500 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 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

Billings Company
If the new line is added, then the Net operating Income will be :-
Contribution margin = 9350000 * 35 % = $ 3272500
Less:- Fixed expenses = $ 2560500
Net operating Income = $ 712000
Part 1	Present	New line	Total
Sales (a)	21750000	9350000	31100000
Net operating income (b)	1993400	712000	2705400
Operating assets ©	4338800	2126350	6465150
Margin ( b/a) (d)	9.17%	7.61%	8.70%
Turnover (a/c) (e)	5.012906795	4.397206481	4.810406564
ROI (d * e)	45.94%	33.48%	41.85%
Part 2- I would reject the order
Part 3- Adding the new line would decrease the company's overall ROI
Part 4	Present	New line	Total
Operating assets (a)	4338800	2126350	6465150
Minimum required return (b)	14%	14%	14%
Minimum NOI ( a*b)	607432	297689	905121
Actual NOI (d)	1993400	712000	2705400
Minimum NOI (e)	607432	297689	905121
Residual Income ( d-e)	1385968	414311	1800279
I would accept the order as residual income increases.