Question

Total		Unit
Sales	$	992,000	$	49.60
Variable expenses		595,200		29.76
Contribution margin		396,800		19.84
Fixed expenses		316,800		15.84
Net operating income		80,000		4.00
Income taxes @ 40%		32,000		1.60
Net income	$	48,000	$	2.40

The company had average operating assets of $506,000 during the year.

1. Compute the company’s return on investment (ROI) for the period using the ROI formula stated in terms of margin and turnover.

For each of the following questions, indicate whether the margin and turnover will increase, decrease, or remain unchanged as a result of the events described, and then compute the new ROI figure. Consider each question separately, starting in each case from the data used to compute the original ROI in (1) above.

2. Using Lean Production, the company is able to reduce the average level of inventory by $98,000. (The released funds are used to pay off short-term creditors.)

3. The company achieves a cost savings of $10,000 per year by using less costly materials.

4. The company issues bonds and uses the proceeds to purchase machinery and equipment that increases average operating assets by $127,000. Interest on the bonds is $16,000 per year. Sales remain unchanged. The new, more efficient equipment reduces production costs by $6,000 per year.

5. As a result of a more intense effort by sales people, sales are increased by 20%; operating assets remain unchanged.

6. At the beginning of the year, obsolete inventory carried on the books at a cost of $17,000 is scrapped and written off as a loss.

7. At the beginning of the year, the company uses $176,000 of cash (received on accounts receivable) to repurchase and retire some of its common stock.

Answer 1

1) Margin= Net operating income/Sales

= $80000*100/992000= 8.06%

Turnover= Sales/Average operating assets

= $992000/506000= 1.96 times

ROI= Margin*Turnover

= 8.06%*1.96= 15.80%

2) If the company reduces the average level of inventory by $98000, the average operating assets of the company will also reduced by $98000. So, the new average operating assets

= $506000-98000= $408000

Margin= Net operating income/Sales

= $80000*100/992000= 8.06%

Turnover= Sales/Average operating assets

= $992000/408000= 2.43 times

ROI= Margin*Turnover

=8.06%*2.43= 19.59%

Margin	8.06	%	Unchanged
Turnover	2.43	times	Increase
ROI	19.59	%	Increase

3) If the company achieves a cost saving of $10000 per year, the net operating income of the company will also increases by $10000

New net operating income= $80000+10000= $90000

Margin= Net operating income/Sales

= $90000*100/992000= 9.07%

Turnover= Sales/Average operating assets

= $992000/506000= 1.96 times

ROI= Margin*Turnover

= 9.07%*1.96= 17.78%

Margin	9.07	%	Increase
Turnover	1.96	times	Unchanged
ROI	17.78	%	Increase

4) If the company issue bonds and uses the proceeds to purchase the machinery and equipment for $127000, the average operating assets of the company will increases by $127000. And as the production costs will reduces by $6000 per year the net operating income will increases by $6000 per year. So, the new average operating assets and net operating income will be

New average operating assets= $506000+127000= $633000

New net operating income= $80000+6000= $86000

Margin= Net operating income/Sales

= $86000*100/992000= 8.67%

Turnover= Sales/Average operating assets

= $992000/633000= 1.57 times

ROI= Margin*Turnover

= 8.67%*1.57= 13.61%

Margin	8.67	%	Increase
Turnover	1.57	times	Decrease
ROI	13.61	%	Decrease

5)

Sales (992000*1.20)	$1190400
Variable expenses	714240
Contribution margin	476160
Fixed expenses	316800
Net operating income	$159360

Variable expenses= $(595200/992000)*1190400= $714240

Margin= Net operating income/Sales

= $159360*100/1190400= 13.39%

Turnover= Sales/Average operating assets

= $1190400/506000= 2.35 times

ROI= Margin*Turnover

= 13.39%*2.35= 31.47%

Margin	13.39	%	Increase
Turnover	2.35	times	Increase
ROI	31.47	%	Increase

6) If the obsolete inventory $17000 is scrapped the net operating income and average operating assets will also reduce by $17000

New net operating income= $80000-17000= $63000

New average operating assets= $506000-17000= $489000

Margin= Net operating income/Sales

= $63000*100/992000= 6.35%

Turnover= Sales/Average operating assets

= $992000/489000= 2.03 times

ROI= Margin*Turnover

= 6.35%*2.03= 12.89%

Margin	6.35	%	Decrease
Turnover	2.03	times	Increase
ROI	12.89	%	Decrease

7) If the company uses cash $176000 to repurchase and retire its common stock, the average operating assets will decrease by $176000

New average operating assets= $506000-176000= $330000

Margin= Net operating income/Sales

= $80000*100/992000= 8.06%

Turnover= Sales/Average operating assets

= $992000/330000= 3.01 times

ROI= Margin*Turnover

= 8.06%*3.01= 24.26%

Margin	8.06	%	Unchanged
Turnover	3.01	times	Increase
ROI	24.26	%	Increase