Question

Effect of Proposals on Divisional Performance

A condensed income statement for the Electronics Division of Gihbli Industries Inc. for the year ended December 31 is as follows:

Sales	$3,190,000
Cost of goods sold	2,362,100
Gross profit	$ 827,900
Operating expenses	477,000
Income from operations	$ 350,900
Invested assets	$2,900,000

Assume that the Electronics Division received no charges from service departments.

The president of Gihbli Industries Inc. has indicated that the division’s return on a $2,900,000 investment must be increased to at least 14.3% 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 $580,000 to other divisions at no gain or loss and lease similar equipment. The annual lease payments would be less than the amount of depreciation expense on the old equipment by $104,400. This decrease in expense would be included as part of the cost of goods sold. Sales would remain unchanged.

Proposal 2: Reduce invested assets by discontinuing a product line. This action would eliminate sales of $616,300, reduce cost of goods sold by $411,800, and reduce operating expenses by $181,300. Assets of $1,468,300 would be transferred to other divisions at no gain or loss.

Proposal 3: Purchase new and more efficient machinery and thereby reduce the cost of goods sold by $382,800 after considering the effects of depreciation expense on the new equipment. Sales would remain unchanged, and the old machinery, which has no remaining book value, would be scrapped at no gain or loss. The new machinery would increase invested assets by $1,450,000 for the year.

Required:

1. Using the DuPont formula for return on investment, determine the profit margin, investment turnover, and return on investment for the Electronics Division for the past year. Round your answers to one decimal place.

	Electronics Division
Profit margin
Investment turnover
ROI

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1. Income from operations divided by sales equals profit margin. Sales divided by invested assets equals investment turnover. Multiply these two values for the rate of return.

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

Gihbli Industries Inc.—Electronics Division
Estimated Income Statements
For the Year Ended December 31
	Proposal 1	Proposal 2	Proposal 3
Sales
Cost of goods sold
Gross profit
Operating expenses
Income from operations
Invested assets

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2. For each proposal, subtract operating expenses from gross profit.

3. Using the DuPont formula for return on investment, determine the profit margin, investment turnover, and return on investment for each proposal. Round your answers to one decimal place.

Proposal	Profit Margin	Investment Turnover	ROI
Proposal 1
Proposal 2
Proposal 3

4. Which of the three proposals would meet the required 14.3% return on investment.

Proposal 1	Meets - Correct
Proposal 2	Meets - Correct
Proposal 3	Meets - Correct

5. If the Golf 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 14.3% return on investment? Enter your increase in investment turnover answer as a percentage of current investment turnover. If required, round your answer to one decimal place.
fill in the %

Answer 1

Solution

Gihbi Industries

Electronics Division

1. Computation of margin, turnover and ROI for the past year:

DuPont Formula

Profit margin –

Profit margin = margin/sales

Margin = operating income

Operating income = $350,900

Sales = $3,190,000

Profit margin = 350,900/3,190,000 = 11%

Turnover -
turnover = sales/invested assets

Invested assets = $2,900,000

Turnover = 3,190,000/2,900,000 = 1.1

Return on Investment (ROI) – DuPont Formula

ROI = profit margin x turnover

= 11% x 1.1 = 12.10%

2. Condensed estimated income statement and computation of the invested assets for each proposal:

Computations –

Proposal 1 –

Sales – unchanged = $3,190,000

Cogs = decrease by 104,400 to equal $2,257,700

Operating expenses remain unchanged – 477,000

Invested assets = 2,900,000 – 580,000 = $2,320,000

Profit margin = 455,300/3,190,000 = 14.27%

Turnover = 3,190,000/2,320,000 = 1.375

ROI = 14.27% x 1.375 = 19.62%

Proposal 2:

Sales = reduce by 616,300 to equal = 3,190,000 – 616,300 = 2,573,700

Cogs = reduce by 411,800 to equal = 2,362,100 – 411,800 = $1,950,300

Operating expenses = 477,000 – 181,300 = $295,700

Income from operations – 327,700

Profit margin = 327,700/2,573,700 = 12.73%

Turnover –

Invested assets = 2,900,000 – 1,468,300 = $1,431700

Turnover = 2573,700/1,431,700 = 1.80

ROI = 12.73 x 1.8 = 32,36%

Proposal 3 –

Sales – unchanged = 3,190,000

Cogs = 2,362,100 – 382,800 = 1,979,300

Operating expenses = 477,000

Income from operations = 733,700

Profit margin = 733,700/3,190,000 = 23%

Turnover –

Invested assets = 2900,000 + 1,450,000 = 4,350,000

Turnover = 3,190,000/4,350,000 = 0.733

ROI = 23% x 0.733 = 16.87%

3. Profit, turnover, roi –

4. All of the three proposals meet the required 14.3% return on investment.

5. Computation of desired investment turnover to increase the required 14.3% ROI:

Profit margin = 11%

Target ROI = 14.3%

Investment turnover =?

As per DuPont Formula, ROI = profit margin x turnover

Turnover = ROI/profit margin

Desired turnover = 14.3/11 = 1.3

Current turnover = 1.1

Increase percent = (1.3 – 1.1)/1.1 = 18.2%