Question

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

	Total		Unit
Sales	$	1,002,000	$	50.10
Variable expenses		601,200		30.06
Contribution margin		400,800		20.04
Fixed expenses		322,800		16.14
Net operating income		78,000		3.90
Income taxes @ 40%		31,200		1.56
Net income	$	46,800	$	2.34

The company had average operating assets of $502,000 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 $92,000. (The released funds are used to pay off short-term creditors.)

3. The company achieves a cost savings of $12,000 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 $125,000. Interest on the bonds is $11,000 per year. Sales remain unchanged. The new, more efficient equipment reduces production costs by $6,000 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 $20,000 is scrapped and written off as a loss.

7. At the beginning of the year, the company uses $177,000 of cash (received on accounts receivable) to repurchase and retire some of its common stock.

Compute the company’s return on investment (ROI) for the period using the ROI formula stated in terms of margin and turnover. (Round your intermediate calculations and final answer to 2 decimal places.)

	Margin % Turnover ROI %

Using Lean Production, the company is able to reduce the average level of inventory by $92,000. (The released funds are used to pay off short-term creditors.) (Round your intermediate calculations and final answer to 2 decimal places.)

	Effect Margin % Turnover ROI %

.

The company achieves a cost savings of $12,000 per year by using less costly materials. (Round your intermediate calculations and final answer to 2 decimal places.)

	Effect Margin % Turnover ROI %

The company issues bonds and uses the proceeds to purchase machinery and equipment that increases average operating assets by $125,000. Interest on the bonds is $11,000 per year. Sales remain unchanged. The new, more efficient equipment reduces production costs by $6,000 per year. (Do not round intermediate calculations and round your final answers to 2 decimal places.)

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	Effect Margin % Turnover ROI %

As a result of a more intense effort by sales people, sales are increased by 25%; operating assets remain unchanged. (Round your intermediate calculations and final answer to 2 decimal places.)

	Effect Margin % Turnover ROI %

At the beginning of the year, obsolete inventory carried on the books at a cost of $20,000 is scrapped and written off as a loss. (Round your intermediate calculations and final answer to 2 decimal places.)

	Effect Margin % Turnover ROI %

At the beginning of the year, the company uses $177,000 of cash (received on accounts receivable) to repurchase and retire some of its common stock. (Round your intermediate calculations and final answer to 2 decimal places.)

	Effect Margin % Turnover ROI %

Answer 1

1	ROI=Margin*Turnover
	Margin=Net operating income/Sales=78000/1002000=0.077844=7.78%
	Turnover=Sales/Average operating assets=1002000/502000=2
	ROI=7.78%*2=15.56%
2	Average level of inventory decreased by $ 92000
	This will decrease the average operating assets by $ 92000
	Average operating assets=502000-92000=$ 410000
	Turnover=Sales/Average operating assets=1002000/410000=2.44
	Turnover will increase
	Margin remains unchanged
	ROI=7.78%*2.44=18.98%
	ROI will increase
3	Cost savings of $12000
	Revised net operating income=78000+12000=$ 90000
	Margin=Net operating income/Sales=90000/1002000=0.08982=8.98%
	Margin will increase
	Turnover remains unchanged
	ROI=8.98%*2=17.96%
	ROI will increase
4	Average operating assets increased by $ 125000
	Average operating assets=502000+125000=$ 627000
	Interest expense will not affect net operating income since it is a non-operating expense
	Cost savings of $ 6000 per year
	This will increase the net operating income by $ 6000
	Net operating income=78000+6000=$ 84000
	Margin=Net operating income/Sales=84000/1002000=0.08383=8.38%
	Margin will increase
	Turnover=Sales/Average operating assets=1002000/627000=1.60
	Turnover will decrease
	ROI=8.38%*1.60=13.41%
	ROI will decrease
5	Sales increased by 25%
	Sales=1002000*125%=$ 1252500
	Operating income:
				$
	Sales			1252500
	Less: variable expenses
	(Note:1)			751500
	Contribution margin			501000
	Less: Fixed expenses			322800
	Net operating income			178200
	Note:1
	Variable expense ratio=Variable expenses/Sales=30.06/50.10=0.60
	Revised variable expense=Revised sales*Variable expense ratio=1252500*0.60=$ 751500
	Margin=Net operating income/Sales=178200/1252500=0.1423=14.23%
	Margin will increase
	Turnover=Sales/Average operating assets=1252500/502000=2.50
	Turnover will increase
	ROI=14.23%*2.50=35.58%
	ROI will increase
6	Obsolete inventory costing $ 20000 is scrapped
	Sales will not be affected by this since sale of scrap can't be included in sales
	Loss on sale of scrap will not affect net operating income since it is a non-operating item
	This will decrease the average operating assets by $ 20000
	Average operating assets=502000-20000=$ 482000
	Margin remains unchanged
	Turnover=Sales/Average operating assets=1002000/482000=2.08
	Turnover will increase
	ROI=7.78%*2.08=16.18%
	ROI will increase
7	Company uses cash of $ 177000
	This will decrease the average operating assets by $ 177000
	Average operating assets=502000-177000=$ 325000
	Turnover=Sales/Average operating assets=1002000/325000=3.08
	Turnover will increase
	Margin remains unchanged
	ROI=7.78%*3.08=23.96%
	ROI will increase