Question

The income statement for Huerra Company for last year is provided below:

			Total			Unit
Sales			$	15,400,000		$	154.00
Less: Variable expenses				12,320,000			123.20
Contribution margin				3,080,000			30.80
Less: Fixed expense				1,540,000			15.40
Net operating income				1,540,000			15.40
Less: Income taxes @ 30%				462,000			4.62
Net income			$	1,078,000		$	10.78

The company had average operating assets of $14,000,000 during the year.

Required:

1.	Compute the company’s ROI for the period using the ROI formula stated in terms of margin and turnover. (Round intermediate calculation to 2 decimal places. Enter your percentage answer rounded to 2 decimal places (i.e., 0.1234 should be entered as 12.34).)

       

2.	Consider each of the following questions separately and then compute the new ROI figure. Indicate whether the ROI will increase, decrease, or remain unchanged as a result of the events described.

a.	By using JIT, the company is able to reduce the average level of inventory by $500,000. (The released funds are used to pay off short-term creditors.) (Round intermediate calculation to 2 decimal places. Enter your percentage answer rounded to 2 decimal places (i.e., 0.1234 should be entered as 12.34).)

             

b.	The company achieves a savings of $8 per unit by using cheaper materials. (Round intermediate and final answer to 2 decimal places.)

             

c.	The company issues bonds and uses the proceeds to purchase machinery and equipment, thus increasing the average assets by $600,000. Interest on the bonds is $60,000 per year. Sales remain unchanged. The new more efficient equipment reduces fixed production costs by $30,000 per year. (Round intermediate and final answer to 2 decimal places.)

             

d.	As a result of a more intense effort by the sales staff, sales are increased by 20%; operating assets remain unchanged. (Round intermediate and final answer to 2 decimal places.)

             

e.	Obsolete items of inventory carried on the records at a cost of $80,000 are scrapped and sold for 25% of the book value. (Use full amount of scrap while calculating average operating assets. Round intermediate calculation to 2 decimal places. Enter your percentage answer rounded to 2 decimal places (i.e., 0.1234 should be entered as 12.34).)

             

f.

The company uses $200,000 in cash (received on accounts receivable) to repurchase and retire some of its common shares. The net effect of this transaction is a $200,000 change in average operating assets. (Use full amount of scrap while calculating average operating assets. Round intermediate calculation to 2 decimal places. Enter your percentage answer rounded to 2 decimal places (i.e., 0.1234 should be entered as 12.34).)

             

g.	The company pays a cash dividend to its shareholders, which results in a $500,000 change in average operating assets. (Round intermediate calculation to 2 decimal places. Enter your percentage answer rounded to 2 decimal places (i.e., 0.1234 should be entered as 12.34).)

Answer 1

Solution

Huerra Company

1. Computation of ROI:

ROI = margin x turnover
margin = net operating income/sales

Net operating income = $1,540,000

Sales = $15,400,000

Margin = (1,540,000/15,400,000) x 100 = 10%

Turnover = sales/average operating assets

Average operating assets = $14,000,000

Turnover = 15,400,000/14,000,000 = 1.1 times

ROI = 10% x 1.1 = 11%

Margin	10%
Turnover	1.1
ROI	11%

2. Computations:

a. Computation of ROI when inventory reduced by $500,000:

	Original	Revised	Effect
Margin	10%	10%	No Effect
Turnover	1.1	1.14	Increase
ROI	11%	11.41%	Increase

When Inventory reduces, average operating assets reduce by $500,000.

Hence, average operating assets = 14,000,000 – 500,000 = $13,500,000

Margin remains unchanged at 10%, as the figures of net operating income and sales remain unchanged.

Turnover = 15,400,000/13,500,000 = 1.14

Hence, Turnover increases when operating assets reduce.

ROI = 10% x 1.14 = 11.41%

Hence, ROI Increases when average operating assets reduce.

b. Computation of ROI when Cost savings of $8 per unit, net cost savings = $8 x 100,000 = $800,000:

	Original	Revised	Effect
Margin	10%	15.20%	Increase
Turnover	1.1	1.1	No Effect
ROI	11%	16.71%	Increase

Cost savings of $800,000 indicates increase in operating income by $800,000

Hence operating income = 1,540,000 + 800,000 = $2,340,000

Margin = (2,340,000/15,400,000) x 100 = 15.20%

Hence, margin increases with cost savings of $800,000.

Turnover remains unchanged at 1.1 since no change in average operating assets and sales values.

ROI =15.20% x 1.1 = 16.71%

Hence, ROI increases with cost savings of $800,000.

a. Increase in operating assets by $600,000; interest expense $60,000; and cost reduction by $30,000;

	Original	Revised	Effect
Margin	10%	10.20%	Increase
Turnover	1.1	1.05	Decrease
ROI	11%	11.25%	Increase

Revised average operating assets = 14,000,000 + 600,000 = $14,600,000

Revised net operating income = 1,540,000 + cost reduction of $30,000 = $1,570,000

Sales remain unchanged

Interest expense is not relevant for computation of net operating income.

Revised

Margin = (1,570,000/15,400,000) x 100 = 10.20%

Turnover = 15,400,000/14,600,000 = 1.05

ROI = 10.2% x 1.05 = 11.25%

b. Increase in sales by 20% ;

	Original	Revised	Effect
Margin	10%	11.67%	Increase
Turnover	1.1	1.32	Increase
ROI	11%	15.40%	Increase

Sales = 15,400,000 + 20% x 15,400,000 = $18,480,000

Contribution margin ratio (original) = 3,080,000/15,400,000 = 20%

Revised contribution margin = 18,480,000 x 20% = $3,696,000

Less: fixed expenses = $1,540,000

Net operating income = $2,156,000

Margin = 2,156,000/18,480,000 = 11.67%

Turnover= 18,480,000/14,000,000 = 1.32

ROI = 11.67% x 1.32 = 15.40%

c. Obsolete inventory written off as loss $80,000

	Original	Revised	Effect
Margin	10%	9.50%	Decrease
Turnover	1.1	1.11	Increase
ROI	11%	10.51%	Decrease

Net operating income decrease by $80,000

= 1,540,000 – 80,000 = $1,460,000

Average operating assets decrease by $80,000

14,000,000 – 80,000 = $13,920,000

Margin = 1,460,000/15,400,000 = 9.50%

Turnover = 15,400,000/13,920,000 = 1.11

ROI = 9.5% x 1.11 = 10.51%

d. The use of cash to the extent of $200,000 for repurchase of stock:

	Original	Revised	Effect
Margin	10%	10%	No Effect
Turnover	1.1	1.11	Increase
ROI	11%	11.15%	Increase

Use of $200,000 cash results in decrease of average operating assets by 200,000.

Net effect = 14,000,000 – 200,000 = $13,800,000

The sales remain same hence margin remains same.

Turnover = 15,400,000/13,800,000 = 1.11

ROI = 10% x 1.11 = 11.15%

e. Payment of cash dividends $500,000 results in decrease in average operating assets by $500,000:

	Original	Revised	Effect
Margin	10%	10%	No Effect
Turnover	1.1	1.14	Increase
ROI	11%	11.40%	Increase

Use of $500,000 cash results in decrease of average operating assets by 500,000.

Net effect = 14,000,000 – 500,000 = $13,500,000

The sales remain same hence margin remains same.

Turnover = 15,400,000/13,500,000 = 1.14

ROI = 10% x 1.14 = 11.40%