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	$	22,300,000
Variable expenses		13,999,600
Contribution margin		8,300,400
Fixed expenses		6,115,000
Net operating income	$	2,185,400
Divisional average operating assets	$	5,575,000

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 $3,857,400. The cost and revenue characteristics of the new product line per year would be:

Sales	$9,650,000
Variable expenses	65% of sales
Fixed expenses	$2,583,600

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

1. Office Products Division's ROI for this year = Net operating income / Divisional average operating assets = $2,185,400 / $5,575,000 = 39.20%.

2. Office Products Division's ROI for the new product line = Net operating income of the new product line / Average investment required in the new product line
where, Net operating income of the new product line = Sales - Variable expenses - Fixed expenses = $9,650,000 - 65% of $9,650,000 - $2,583,600 = $793,900
ROI for the new product line = $793,900 / $3,857,400 = 20.58%.

3. Office Product's ROI for the next year after adding the new product line = Total net operating income / Total Average operating assets
where, Total net operating income = Net operating income from existing product line + Net operating income from new product line = $2,185,400 + $793,900 = $2,979,300.
Total Average operating assets = Divisional average operating assets on existing product line + Average investment required in the new product line = $5,575,000 + $3,857,400 = $9,432,400.
Office Product's ROI for the next year after adding the new product line = $2,979,300 / $9,432,400 = 31.59%.

4. Reject the new product line as the divisions are evaluated on the basis of the division's ROI. Currently, the office products Division's ROI is 39.20% which is almost double if compared to the ROI of the new product line. So, if the new product line is added to the existing one then the ROI of the division will go down to 31.59%. This means that the division's manager might not get the year-end bonuses next year if he accepts to add on the new product line to the existing one.