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	$	22,700,000
Variable expenses		14,363,700
Contribution margin		8,336,300
Fixed expenses		6,175,000
Net operating income	$	2,161,300
Divisional average operating assets	$	5,675,000

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 $3,938,000. The cost and revenue characteristics of the new product line per year would be:

Sales	$9,800,000
Variable expenses	65% of sales
Fixed expenses	$2,582,900

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

Answer to 1

Office products division's ROI for this year

= Net operating income/ Average operating assets

= $ (2161300/ 5675000)

= 38.08%

Answer to 2

Office products division's ROI for the new product line

Particulars	Amount ($)	Remarks
Sales	9800000
Variable expenses	6370000	65% of sales i.e. (65% X 9800000)
Contribution margin	3430000	Sales - Variable expenses
Fixed expenses	2582900
Net operating income	847100	Contribution margin - Fixed expenses
Average operating assets	3938000
Return on Investment (ROI)	21.51%	Net operating income/ Average operating assets

Answer to 3

Office products division's ROI

Particulars	Existing products ($)	New product ($)	Total
Sales	22700000	9800000	32500000
Variable expenses	14363700	6370000	20733700
Contribution margin	8336300	3430000	11766300
Fixed expenses	6175000	2582900	8757900
Net operating income	2161300	847100	3008400
Average operating assets	5675000	3938000	9613000
Return on Investment (ROI)	38.08%	21.51%	31.30%

Therefore, ROI is 31.30%

Answer to 4

If I were in the position of Dell Havasi's, I would not add the new product line, as overall divisional ROI has declined from 38.08% to 31.30%; which would impact year end bonuses payment.