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	$	22,000,000
Variable expenses		13,500,000
Contribution margin		8,500,000
Fixed expenses		6,000,000
Net operating income	$	2,500,000
Divisional average operating assets	$	4,443,500

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 $2,289,300. The cost and revenue characteristics of the new product line per year would be:

Sales	$9,155,000
Variable expenses	65% of sales
Fixed expenses	$2,543,950

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

Solution 1: 56.262%

Calculation of ROI for Office Product’s division for current year:

Net Operating Income = $2,500,000

Average Operating Assets= $4,443,500

ROI = Net Operating Income / Average Operating Assets * 100

= 2,500,000 / 4,443,500 * 100

= 56.262%

Solution 2: 28.85%

Calculation of ROI for New product line:

Net Operating Income for new product can be computed using the formulae as Sales – Variable cost – Fixed Expenses

= 9,155,000 – 65% * 9,155,000 – 2,543,950

= $660,300

Net Operating Income = $660,300

Average Operating Assets= $2,289,300

ROI = Net Operating Income / Average Operating Assets * 100

= 660,300 / 2,289,300 * 100

= 28.85%

Solution 3: 46.94%

Calculation of ROI for Office Product’s division for next year assuming inclusion of new product line:

Net Operating Income = $2,500,000+ $660,300 = $3,160,300

Average Operating Assets= $4,443,500+ $2,289,300 = $6,732,800

ROI = Net Operating Income / Average Operating Assets * 100

= 3,160,300 / 6,732,800 * 100

= 46.94%

Solution 4: Reject

Since new product line will decrease the ROI from Products division, As Manager of Billings Company’s Office Product Division; it is sensible to reject the offer from headquarter with stating them the reason for rejection of new product line.

Solution 5:

Since New Product Line adds a return of overall 28.85% (as per sol 2) which is quite above the overall return made by company this year (16%). At an overall level, ROI will be improved due to higher ROI from

New product line. It makes the sense for headquarter to introduce line. But why only Products Division? Since Product Division is the key division driving the highest ROI among all 5 divisions. The numbers in Product division can easily absorb 28.85% ROI and can take it higher in future.