Question

Effect of Proposals on Divisional Performance

A condensed income statement for the Jet Ski Division of Amazing Rides Inc. for the year ended December 31, 20Y2, is as follows:

Sales	$3,850,000
Cost of goods sold	(2,668,500)
Gross profit	$ 1,181,500
Operating expenses	(681,000)
Operating income	$ 500,500
Invested assets	$3,500,000

Assume that the Jet Ski Division received no charges from service departments. The president of Amazing Rides has indicated that the division’s rate of return on a $3,500,000 investment must be increased to at least 18.2% by the end of the next year if operations are to continue. The division manager is considering the following three proposals:

Proposal 1: Transfer equipment with a book value of $700,000 to other divisions at no gain or loss and lease similar equipment. The annual lease payments would exceed the amount of depreciation expense on the old equipment by $126,000. This increase in expense would be included as part of the cost of goods sold. Sales would remain unchanged.

Proposal 2: Purchase new and more efficient machining equipment and thereby reduce the cost of goods sold by $462,000. Sales would remain unchanged, and the old equipment, which has no remaining book value, would be scrapped at no gain or loss. The new equipment would increase invested assets by an additional $1,750,000 for the year.

Proposal 3: Reduce invested assets by discontinuing the tandem jet ski line. This action would eliminate sales of $743,800, cost of goods sold of $497,000, and operating expenses of $218,800. Assets of $1,772,100 would be transferred to other divisions at no gain or loss.

Required:

1. Using the DuPont formula for return on investment, determine the profit margin, investment turnover, and return on investment for the Jet Ski Division for the past year. For investment turnover and ROI, round to one decimal place.

	Jet Ski Division
Profit margin		%
Investment turnover
ROI		%

2. Prepare condensed estimated income statements and compute the invested assets for each proposal.

Amazing Rides Inc.-Jet Ski Division
Estimated Income Statements
For the Year Ended December 31, 20Y2
	Proposal 1	Proposal 2	Proposal 3
	$	$	$
	$	$	$
	$	$	$
Invested assets	$	$	$

3. Using the DuPont formula for return on investment, determine the profit margin, investment turnover, and return on investment for each proposal. Round interim calculations (including previously calculated) and final answer to one decimal place.

	Profit margin	Investment turnover	ROI
Proposal 1:	%		%
Proposal 2:	%		%
Proposal 3:	%		%

4. Select whether each of the three proposals would meet the required 18.2% return on investment.

Proposal 1:  

Proposal 2:  

Proposal 3:  

5. If the Jet Ski Division were in an industry where the profit margin could not be increased, how much would the investment turnover have to increase to meet the president's required 18.2% return on investment? Round intermediate calculations to two decimal places and your final answer to one decimal place.
%

Answer 1

1).

Profit Margin = Operating Income/Sales
= $500,500 / $3,850,000
= 13%

Investment Turnover = Sales / Invested Assets
= $3,850,000 / $3,500,000
= 1.1

ROI = Profit Margin x Investment Turnover
= 13% x 1.1
= 14.3%

5).

Profit Margin = 13%
Required ROI = 18.2%

Required Investment Turnover = 18.2%/13%
= 1.4

Increase in investment turnover required = (1.4-1.1)/1.1
= 27.3%