Question

Problem 11-18 Return on Investment (ROI) and Residual Income [LO11-1, LO11-2]

“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	$	22,100,000
Variable expenses		13,893,400
Contribution margin		8,206,600
Fixed expenses		6,085,000
Net operating income	$	2,121,600
Divisional average operating assets	$	5,200,000

The company had an overall return on investment (ROI) of 16.00% 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 $2,387,500. The cost and revenue characteristics of the new product line per year would be:

Sales	$9,550,000
Variable expenses	65% of sales
Fixed expenses	$2,578,500

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 12% 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

	Present	New Line	Total
Sales	$22,100,000	$9,550,000	$31,650,000
Net operating income (2)	$2,121,600	$764,000[$9,550,000*35%]-$2,578,500	$2,885,600 [$2,121,600+764,000]
Operating assets (3)	$5,200,000	$2,387,500	$7,587,500
ROI (2)/(3)	40.8%	32%	38.03%
	1	2	3

New line net income = sales-variable cost-fixed cost

(1)ROI = 40.8%

(2) ROI = 32%

(3) ROI =38.03%

(4)By accepting new offer the ROI of office division will reduce from 40.8% to 38.03%

so NO, as a manager i will not accept the offer

(5) The ROI of new offer 32% is more than company's ROI of 16%

by adding new offer the overall company's ROI will improve/Increase

This is the reason headquarters is anxious for the Office Products Division to add the new product line.

(6) residual income = Actual income-minimum required return

	Present	New Line	Total
Actual income(A)	$2,121,600	$764,000[$9,550,000*35%]-$2,578,500	$2,885,600
Operating assets	$5,200,000	$2,387,500	$7,587,500
minimum required return	12%	12%	12%
Minimum net operating incoem required (B)	$624,000($5,200,000*12%)	$286,500($2,387,500*12%)	$910,500($7,587,500*12%)
residualincome [A-B]	$1,497,600 Answer 6a	$477,500 Answer 6b	$1,975,100 Answer 6c

6d.under residual income approach Hell devasi would be inclined to accept the offer as it will incraese residual income of its division from $1,497,600 to $1,975,100