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 the most recent 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 operating assets $ 5,675,000 The company had an overall return on investment (ROI) of 16.00% last year (considering all divisions). The Office Products Division has an opportunity to add a new product line that would require an additional investment in operating assets of $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 the most recent year; also compute the ROI as it would appear if the new product line is added. (Round the "Margin", "Turnover" and "ROI" answers to 2 decimal places.) 2. If you were in Dell Havasi’s position, would you accept or reject the new product line? Accept Reject 3. Why do you suppose headquarters is anxious for the Office Products Division to add the new product line? Adding the new line would Increase the company's overall ROI. Adding the new line would Decrease the company's overall ROI. 4. Suppose that the company’s minimum required rate of return on operating assets is 13.00% and that performance is evaluated using residual income. a. Compute the Office Products Division’s residual income for the most recent year; also compute the residual income as it would appear if the new product line is added. b. Under these circumstances, if you were in Dell Havasi’s position, would you accept or reject the new product line? Accept Reject

Answer 1

Solution

Billings Company

1. Computation of the Office Products Division’s ROI for the most recent year –

ROI = net operating income/divisional operating assets

Net operating income = $2,161,300

Divisional operating assets = $5,675,000

ROI = (2,161,300/5,675,000) x 100 = 38.10%

ROI if new product line is added:

Net operating income of new product line –

Sales = $9,800,000

Variable expenses, 65% of sales = $6,370,000

Contribution margin, 35% of sales = $3,430,000

Fixed cost = $2,582,900

Net operating income = 847,100

Total sales = 22,700,000 + 9,800,000 = $32,500,000

Total net operating income when new product added = $2,161,300 + 847,100 = $3,008,400

Total divisional assets = $5,675,000 + $3,938,000 = $9,613,000

ROI if new product line is added = (3,008,400/9,613,000) x 100 = 31.30%

Alternatively,

ROI = margin x turnover

Margin = operating income/sales = 3,008,400/32,500,000 = 9.3%

Turnover = sales/operating assets = 32,500,000/9,613,000 = 3.38

ROI = 9.3% x 3.38 = 31.3%

1. Reject the new product line

Adding the new product line would decrease the company’s overall ROI.

Explanation: The ROI after new product line is added is 31.3%, which is less than the ROI, 38.1% of current product line. Hence, REJECT.

1. Computation of residual income assuming minimum required rate of return is 13% –

• For most recent year

Operating assets = $5,675,000
minimum required return = 13% x 5,675,000 = $737,750

Operating income = $2,161,300

Residual income = 2,161,300 – 737,750 = $1,423,550

• If new product line is added

Operating assets = $5,675,000 + $3,938,000 = $9,613,000

Minimum return = 13% x 9,613,000 = $1,249,690

Total net operating income when new product added = $2,161,300 + 847,100 = $3,008,400

Residual income = 3,008,400 – 1,249,690 = $1,758,710

Accept the proposal

Explanation –The residual income when new product line is added increases by $335,160 as compared to the residual income from the most recent operations.