Question

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

	Total		Unit
Sales	$	1,008,000	$	50.40
Variable expenses		604,800		30.24
Contribution margin		403,200		20.16
Fixed expenses		323,200		16.16
Net operating income		80,000		4.00
Income taxes @ 40%		32,000		1.60
Net income	$	48,000	$	2.40

The company had average operating assets of $495,000 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 $9,000 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 $121,000. Interest on the bonds is $17,000 per year. Sales remain unchanged. The new, more efficient equipment reduces production costs by $7,000 per year.

5. As a result of a more intense effort by sales people, sales are increased by 25%; operating assets remain unchanged.

6. At the beginning of the year, obsolete inventory carried on the books at a cost of $17,000 is scrapped and written off as a loss.

7. At the beginning of the year, the company uses $178,000 of cash (received on accounts receivable) to repurchase and retire some of its common stock.

Answer 1

ANSWER:

	Total	Unit
Sales	1,008,000	50.40
Variable expenses	604,800	30.24
Contribution margin	403,200	20.16
Fixed expenses	323,200	16.16
Net operating income	80,000	4.00
Income taxes @ 40%	32,000	1.60
Net income	48,000	2.40

Average operating assets = $495,000

Requirement 1: Company’s return on investment (ROI)

Particulars	Amount
Sales	1,008,000
Net operating income (NOI)	80,000
Operating Assets	495,000
Margin (NOI / Sales) * 100	7.93%
Turnover (Sales / Operating Assets)	2.03
ROI (Margin * Turnover) * 100	16.09%

Requirement 2:

If the company, reduce the average level of inventory by $109,000

Particulars	Amount	Effect
Sales	1,008,000
Net operating income (NOI)	80,000
Operating Assets (495,000 - 109,000)	386,000‬
Margin (NOI / Sales) * 100	7.93%	Unchanged
Turnover (Sales / Operating Assets)	2.61	Increase
ROI (Margin * Turnover) * 100	20.69%	Increase

Requirement 3:

If the Company achieves a cost savings of $9,000 per year

Particulars	Amount	Effect
Sales	1,008,000
Net operating income (NOI) (80,000 + 9,000)	89,000
Operating Assets	495,000
Margin (NOI / Sales) * 100	8.82%	Increase
Turnover (Sales / Operating Assets)	1.98	Unchanged
ROI (Margin * Turnover) * 100	17.46%	Increase

Requirement 4:

Company issues bonds, increases average operating assets by $121,000, reduce production costs by $7,000 per year.

Particulars	Amount	Effect
Sales	1,008,000
Net operating income (NOI) (80,000 + 7,000)	87,000
Operating Assets (495,000 + 121,000)	616,000
Margin (NOI / Sales) * 100	8.63%	Increase
Turnover (Sales / Operating Assets)	1.63	Decrease
ROI (Margin * Turnover) * 100	14.06%	Decrease

Requirement 5:

Sales are increased by 25%

Particulars	Amount	Effect
Sales [1,008,000 + (25% of 1,008,000)]	1,260,000‬
Less: Variable Expense	(604,800)
Contribution margin	655,200‬
Less: Fixed expenses	(323,200)
Net operating income (NOI)	332,000‬
Operating Assets	495,000
Margin (NOI / Sales) * 100	26.34%	Increase
Turnover (Sales / Operating Assets)	2.54	Increase
ROI (Margin * Turnover) * 100	66.90%	Increase

Requirement 6:

Obsolete inventory carried on the books at a cost of $17,000 is scrapped and written off as a loss

Particulars	Amount	Effect
Sales	1,008,000
Net operating income (NOI) (80,000 - 17,000)	63,000‬
Operating Assets (495,000 - 17,000)	478,000‬
Margin (NOI / Sales) * 100	6.25‬%	Decrease
Turnover (Sales / Operating Assets)	2.10	Increase
ROI (Margin * Turnover) * 100	13.12%	Decrease

Requirement 7:

At the beginning of the year, the company uses $178,000 of cash (received on accounts receivable) to repurchase and retire some of its common stock.

Particulars	Amount	Effect
Sales	1,008,000
Net operating income (NOI)	80,000
Operating Assets (495,000 - 178,000)	317,000‬
Margin (NOI / Sales) * 100	7.93%	Unchanged
Turnover (Sales / Operating Assets)	3.17	Increase
ROI (Margin * Turnover) * 100	25.13%	Increase