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	$	22,505,000
Variable expenses		14,105,500
Contribution margin		8,399,500
Fixed expenses		6,145,000
Net operating income	$	2,254,500
Divisional average operating assets	$	4,687,500

The company had an overall return on investment (ROI) of 17.00% 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 $3,261,000. The cost and revenue characteristics of the new product line per year would be:

Sales	$9,750,000
Variable expenses	65% of sales
Fixed expenses	$2,595,300

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 14% 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

Calculation of net operating income for the new product line

Sales	$9,750,000
Less: Variable Expenses (65%)	($6,337,500)
Contribution margin	$3,412,500
Less: Fixed expenses	($2,595,300)
Net operating income	$817,200

Return on investment = net operating income/ Average operating Assets

1. ROI for this year

=$2,254,500/$4,687,500

=48.09%

2. ROI for the new product line

=$817,200/$3,261,000

=25.05%

3. ROI for the next year

=$3,071,700/$7,948,500

=38.64%

4. Reject as ROI Decreases

5. Adding the new product line would increase in company's overall ROI

6a.

Residual income for this year

Average operating Assets× Minimum required rate of return = Minimum required Return

=$4,687,500×14%

=$656,250

Residual income = Actual net operating income- minimum required Return

=$2,254,500-$656,250

=$1,598,250

6b.

Residual income for the new product line

=$3,261,000×14%

=$456,540

Residual income =$817,200-$456,540

=$360,660

6c. Residual income for the next year

= $7,948,500×14%

=$1,112,790

Residual income = $3,071,700-$1,112,790

=$1,958,910

6d. Accept as Residual income increases

______×______