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	$	23,000,000
Variable expenses		14,365,000
Contribution margin		8,635,000
Fixed expenses		6,220,000
Net operating income	$	2,415,000
Divisional average operating assets	$	5,001,000

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 $2,501,000. The cost and revenue characteristics of the new product line per year would be:

Sales	$10,100,000
Variable expenses	65% of sales
Fixed expenses	$2,644,900

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 13% 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

	This Year		New Product Line		Next Year
Sales	23,000,000		10100000		33100000
Variable expenses	14365000		6565000		20930000
Contribution Margin	8635000		3535000		12170000
Fixed Expenses	6220000		2644900		8864900
Net Operating Income	2415000		890100		3305100
Average Operating Assets	5001000		2501000		7502000
Return on Investment = Net Operating Income / Average Operating Assets
This Year = 2,415,000 / 5,001,000
= 48.29%
Return on Investment = Net Operating Income / Average Operating Assets
New Product Line = 890,100 / 2,501,000
= 35.59 %
Return on Investment = Net Operating Income / Average Operating Assets
Next Year = 3,305,100 / 7,502,000
= 44.06 %
Reject the new product line, because the ROI of Last year is more as comparision to ROI when new product Line is added. And if the new product line is accepted then the overall ROI of the Division will decline.
Adding the new line would increase the Company's overall ROI.
	This Year		New Product Line		Next Year
Operating Assets	5001000		2501000		7502000
Net Operating Income	2415000		890100		3305100
Minus the Minimum Required return on Operating Assets	650130		325130		975260
Residual Income	1764870		564970		2329840
Minimum Required Return on Operating = Operating Assets * Minimum Required rate of return
This Year = $ 5,001,000 * 13% = $ 650,130
New Line = $ 2,501,000 * 13% = $ 564,970
Next Year = $ 7,502,000 * 13% = $ 2,329,840
Residual Income = Acual Net Operating Income - Minimum Net Operating Income
Last Year = $ 2,415,000 - 650,130 = $ 1,764,870
New Product Line = $ 890,100 - 325,130 = $ 564,970
Next Year = $ 3,305,100 - 975,260 = $ 2,329,840
The new product line should be accepted.