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 $ 21,600,000 Variable expenses 13,622,600 Contribution margin 7,977,400 Fixed expenses 6,010,000 Net operating income $ 1,967,400 Divisional average operating assets $ 4,499,200 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 $2,326,200. The cost and revenue characteristics of the new product line per year would be: Sales $9,300,000 Variable expenses 65% of sales Fixed expenses $2,557,400 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

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Billing's Company
Ans 1
Particulars	Amount ($)
Sales	21,600,000.00	A
Variable Expenses	13,622,600.00	B
Contribution Margin	7,977,400.00	C=A-B
Fixed Expenses	6,010,000.00	D
Operating Income	1,967,400.00	E=C-D
Average Assets	4,499,200.00	F
ROI	43.73%	G=E/F
Ans 2
Particulars	Amount ($)
Sales	9,300,000.00	H
Variable Expenses	6,045,000.00	I=H*65%
Contribution Margin	3,255,000.00	J=H-I
Fixed Expenses	2,557,400.00	K
Operating Income	697,600.00	L=J-K
Average Assets	2,326,200.00	M
ROI	29.99%	N=L/M
Ans 3
Particulars	Amount ($)
Sales	30,900,000.00	O=A+H
Variable Expenses	19,667,600.00	P=B+I
Contribution Margin	11,232,400.00	Q=O-P
Fixed Expenses	8,567,400.00	R=D+K
Operating Income	2,665,000.00	S=Q-R
Average Assets	6,825,400.00	T=F+M
ROI	39.05%	U=S/T
Reduction in ROI by	4.68%	V=G-U

Ans 4- New product line will decrease ROI by 4.68% so it should not be accepted.

Ans 5- Headquarter is anxious because Office products division is doing very well and adding new product line will benefit company as a whole and also keep the division on ground by reducing its ROI but increasing its operating income in monetary terms.

Ans 6 a
Required Rate of return	14%	W
Average Assets	4,499,200.00	See F
Minimum Return	629,888.00	X= W*F
Operating Income	1,967,400.00	See E
Residual Income	1,337,512.00	Y=E-X
Ans 6 b
Required Rate of return	14%	See W
Average Assets	2,326,200.00	See M
Minimum Return	325,668.00	Z=W*M
Operating Income	697,600.00	See L
Residual Income	371,932.00	AA= L-Z
Ans 6 c
Required Rate of return	14%	See W
Average Assets	6,825,400.00	See T
Minimum Return	955,556.00	AB= W*T
Operating Income	2,665,000.00	See S
Residual Income	1,709,444.00	AC=S-AB
Increase in Residual Income by	371,932.00	AD= AC-Y

Ans 6 d- New product line will Increase Residual Income by $ 371,932 so it should be accepted.