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	$	22,900,000
Variable expenses		14,313,400
Contribution margin		8,586,600
Fixed expenses		6,205,000
Net operating income	$	2,381,600
Divisional average operating assets	$	4,580,000

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 $2,484,500. The cost and revenue characteristics of the new product line per year would be:

Sales	$9,942,400
Variable expenses	65% of sales
Fixed expenses	$2,602,240

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

1. ROI of Office Product Division:

ROI = Net Operating Income / Operating Assets X 100

= 2,381,600 / 45,80,000 X 100

= 52%

2. ROI for the new product line by itself:

Particulars	Amount in $
Sales	9,942,400
Less: variable Expenses @ 65%	6,462,560
Contribution	3,479,840
Less: Fixed Cost	2,602,240
Net Operating Income	877,600
Operating Assets	2,484,500
ROI (877,600 / 2,484,500 X 100)	35.32%

3. ROI for next year assuming that it performs the same as this year and adds the new product line:

Particulars	Existing Division	New Division	Total
Operating Income	2,381,600	877,600	3,259,200
Operating Assets	4,580,000	2,484,500	7,064,500
ROI			46.13%

4. Being a Manager of a Company, i should reject the offer as by accepting offer ROI of Office Products Divisions is going to decrease.

5. The combined ROI of all divisions or company as a whole is 17% whereas the new product line offer ROI is 35.32% which almost double the ROI of the Company. Hence its look lucrative to Head office for accepting an offer.

6. Computation of Residual Income:

Particualrs	Existing Division (6a) (In $)	New Division (6b) (In $)	Total (6c)(In $)
Operating Assets...........(A)	4,580,000	2,484,500	7,064,500
Required ROI................(B)	13%	13%	13%
Minimum Operating Income (AXB)...........................(C)	595,400	322,985	918,385
Actual Operating Profit.....(D)	2,381,600	877,600	3,259,200
Residual Income...........(D-C)	1,786,200	554,615	2,340,815

(6d) If we use Rediaul Income approach, it is profitable for the comapny to add new Product line. we can see that by adding new product line company's residual income increase by $ 554,615.