Question

“I know headquarters wants us to add that new product line,” said Fred Halloway, manager of Kirsi Products’ East Division. “But I want to see the numbers before I make a move. Our division’s return on investment (ROI) has led the company for three years, and I don’t want any letdown.” Kirsi Products is a decentralized wholesaler with four autonomous divisions. The divisions are evaluated on the basis of ROI, with year-end bonuses given to divisional managers who have the highest ROI. Operating results for the company’s East Division for last year are given below: Sales $ 16,200,000 Variable expenses 14,000,000 Contribution margin 2,200,000 Fixed expenses 823,000 Net operating income $ 1,377,000 Divisional operating assets $ 5,400,000 The company had an overall ROI of 18% last year (considering all divisions). The company’s East Division has an opportunity to add a new product line that would require an investment of $2,800,000. The cost and revenue characteristics of the new product line per year would be as follows: Sales $ 7,840,000 Variable expenses 65% of sales Fixed expenses $ 2,171,680 Required: 1. Compute the East Division’s ROI for last year; also compute the ROI as it would appear if the company performed the same as last year and added the new product line. (Do not round intermediate percentage values. Round other intermediate calculations and final answers to 2 decimal places.) ROI Present % New product line alone % Total % 2. If you were in Fred Halloway’s position, would you accept or reject the new product line? Accept Reject 3. Why do you suppose headquarters is anxious for the East 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 15% and that performance is evaluated using residual income. a. Compute the East Division’s residual income for last year; also compute the residual income as it would appear if the company performed the same as last year and added the new product line. Residual income Present $ New product line alone $ Total $ b. Under these circumstances, if you were in Fred Halloway's position would you accept or reject the new product line? Accept Reject

Answer 1

1)new product line

SALES $7,840,000

LESS:VARIABLE EXPENSES(65%*7,840,000) $5,096,000

CONTRIBUTION MARGIN $2,744,000

LESS:FIXED COST $2,171,680

NET OPERATING INCOME $572,320

	PRESENT	NEW LINE	TOTAL
SALES(A)	16,200,000	7,840,000	24,040,000
NET OPERATING INCOME(B)	1,377,000	572,320	1,949,320
OPERATING ASSETS(C)	5,400,000	2,800,000	8,200,000
MARGIN(B/A=D)	8.5%	7.3%	8.11%
TURNOVER(A/C=E)	3	2.8	2.93
ROI(D*E)	25.5%	20.44%	23.76%

2.Fred Halloway will be inclined to reject the new product line because accepting it would reduce his division’s overall rate of return.

3. The new product line promises an ROI of 18%, whereas the company’s overall ROI last year was only 20.44%. Thus, adding the new line would increase the company’s overall ROI.

4.a)

	PRESENT	NEW LINE	TOTAL
OPERATING ASSETS(A)	5,400,000	2,800,000	8,200,000
MIN. REQUIRED RATE OF RETURN (B)	15%	15%	15%
MINIMUM OPERATING INCOME(A*B=C)	810,000	420,000	1,230,000
ANNUAL OPERATING INCOME (D)	1,377,000	572,320	1,949,320
MINIMUM NET OPERATING INCOME ABOVE (E)	810,000	420,000	1,230,000
RESIDUAL INCOME(D-E)	567,000	152,320	719,320

b. Under the residual income approach, Fred Halloway's would be inclined to accept the new product line, since adding the product line would increase the total amount of his division’s residual income, as shown above.