Question

Effect of Proposals on Divisional Performance

A condensed income statement for the Electronics Division of Gihbli Industries Inc. for the year ended December 31, 20Y9, is as follows:

Sales	$4,030,000
Cost of goods sold	2,983,700
Gross profit	$ 1,046,300
Operating expenses	603,000
Income from operations	$ 443,300
Invested assets	$3,100,000

Assume that the Electronics Division received no charges from service departments.

The president of Gihbli Industries Inc. has indicated that the division’s return on a $3,100,000 investment must be increased to at least 16.5% by the end of the next year if operations are to continue. The division manager is considering the following three proposals:

Proposal 1: Transfer equipment with a book value of $620,000 to other divisions at no gain or loss and lease similar equipment. The annual lease payments would be less than the amount of depreciation expense on the old equipment by $111,600. This decrease in expense would be included as part of the cost of goods sold. Sales would remain unchanged.

Proposal 2: Reduce invested assets by discontinuing a product line. This action would eliminate sales of $658,800, reduce cost of goods sold by $440,200, and reduce operating expenses by $193,800. Assets of $1,569,500 would be transferred to other divisions at no gain or loss.

Proposal 3: Purchase new and more efficient machinery and thereby reduce the cost of goods sold by $409,200 after considering the effects of depreciation expense on the new equipment. Sales would remain unchanged, and the old machinery, which has no remaining book value, would be scrapped at no gain or loss. The new machinery would increase invested assets by $1,550,000 for the year.

Required:

1. Using the DuPont formula for return on investment, determine the profit margin, investment turnover, and rate of return on investment for the Electronics Division for the past year. Round your answers to one decimal place.

	Electronics Division
Profit margin		%
Investment turnover
ROI		%

2. Prepare condensed estimated income statements and compute the invested assets for each proposal.

Gihbli Industries Inc.—Electronics Division
Estimated Income Statements
For the Year Ended December 31, 20Y9
	Proposal 1	Proposal 2	Proposal 3
Sales	$	$	$
Cost of goods sold
Gross profit	$	$	$
Operating expenses
Income from operations	$	$	$
Invested assets	$	$	$

3. Using the DuPont formula for return on investment, determine the profit margin, investment turnover, and return on investment for each proposal. Round your answers to one decimal place.

Proposal	Profit Margin	Investment Turnover	ROI
Proposal 1	%		%
Proposal 2	%		%
Proposal 3	%		%

4. Which of the three proposals would meet the required 16.5% return on investment.

Proposal 1	Meets
Proposal 2	Meets
Proposal 3	Meets

5. If the Electronics Division were in an industry where the profit margin could not be increased, how much would the investment turnover have to increase to meet the president's required 16.5% rate of return on investment? Enter your increase in investment turnover answer as a percentage of current investment turnover. If required, round your answer to one decimal place.
%

Answer 1

Solution 1:

Profit margin for past year = Net operating income / Sales = $443,300 / $4,030,000 = 11%

Investment turnover for past year = Sales / Average operating assets = $4,030,000 / $3,100,000 = 1.3 times

ROI = Margin * Turnover = 11% * 1.30 = 14.30%

Solution 2:

Gihbli Industries Inc.
Estimated income statement
For the year ended December 31, 20Y9
Particulars	Proposal 1	Proposal 2	Proposal 3
Sales	$4,030,000.00	$3,371,200.00	$4,030,000.00
Cost of goods sold	$2,872,100.00	$2,543,500.00	$2,574,500.00
Gross Profit	$1,157,900.00	$827,700.00	$1,455,500.00
Operating expenses	$603,000.00	$409,200.00	$603,000.00
Income from operations	$554,900.00	$418,500.00	$852,500.00
Invested assets	$2,480,000.00	$1,530,500.00	$4,650,000.00

Solution 3:

Computation of Profit Margin, Investment Turnover and ROI for each proposal
Particulars	Proposal 1	Proposal 2	Proposal 3
Sales	$4,030,000.00	$3,371,200.00	$4,030,000.00
Income from operations	$554,900.00	$418,500.00	$852,500.00
Invested assets	$2,480,000.00	$1,530,500.00	$4,650,000.00
Profit Margin (Net Operating income / Sales)	13.8%	12.4%	21.2%
Investment Turnover (Sales / Invested Assets)	1.6	2.2	0.9
ROI (Margin * Turnover)	22.4%	27.3%	18.3%

Solution 4:

All 3 proposals meets the required 16.5% return on investment.

Solution 5:

Existing profit margin = 11%

If profit margin could not be increased then required investment turnover to meet required return = 16.5 / 11 = 1.5 times

Current investment turnover = 1.3 times

Increase in investment turnvoer = 1.5 - 1.3 = 0.2

% increase in investment turnover = 0.2 / 1.3 = 15.4%