Question

Key information for the Plant City Division (PCD) of Barkley Industries for 2019 are as follows: Revenues $15,000,000 Operating Income 1,800,000 Total Assets 10,000,000 PCD managers are evaluated and rewarded on the basis of ROI defined as operating income divided by total assets. Barkley Industries expects its divisions to increase ROI each year. Next year, 2020, appears to be a difficult year for PCD. PCD had planned a new investment to improve quality but, in view of poor economic conditions, has postponed the investment. ROI for 2020 was certain to decrease if PCD had made the investment. Management is now considering ways to meet its target ROI of 20% for next year. It anticipates revenues to be steady at $15 million in 2020.

Required: (a) Calculate PCD’s return on sales and ROI for 2019.

(b) (1) By how much would PCD need to cut costs in 2020 to achieve its target ROI of 20%, assuming no change in total assets between 2019 and 2020?

(2) By how much would PCD need to decrease total assets in 2020 to achieve its target ROI of 20%, assuming no change in operating income between 2019 and 2020?

(c) Calculate PCD’s Residual Income (RI)* in 2019, assuming a required rate of return on investment of 15%.

(d) PCD wants to increase RI by 50% in 2020. Assuming it could cut costs by $45,000 in 2020, by how much would PCD need to decrease total assets in 2020?

(e) Barkley Industries is concerned that the focus on cost cutting, asset sales and no new investments will have an adverse long-run effect on PCD’s customers. Yet Barkley wants PCD to meet its financial goals. What other measurements, if any do you recommend that Barkley use? Explain briefly. * Residual Income = Operating Income – (Total Assets x Required Rate of Return) [Residual Income as a performance measure has the advantage of motivating managers to act in the best interest of the company as a whole.]

Answer 1

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Plant City Division
Answer a	Amount $	Note
Operating Income	1,800,000.00	A
Revenues	15,000,000.00	B
Return on sales	12.00%	C=A/B
Operating Income	1,800,000.00	See A
Total Asset	10,000,000.00	D
ROI	18.00%	E=A/D
Answer b 1
Total Asset	10,000,000.00	See D
Target ROI	20%	F
Desired ROI	2,000,000.00	G=F*D
Current Operating Income	1,800,000.00	See A
Costs to be cut in 2020	200,000.00	H=G-A
Answer b 2
Desired ROI	2,000,000.00	See G
Current Operating Income	1,800,000.00	See A
Difference	200,000.00	See H
Target ROI	20%	See F
Decrease in total assets in 2020	1,000,000.00	I=H/F
Answer c
Total Asset	10,000,000.00	See D
Required rate of return	15%	J
Required return	1,500,000.00	K=D*J
Operating Income	1,800,000.00	See A
Residual Income	300,000.00	L=A-K
Answer d
Current Operating Income	1,800,000.00	See A
Reduction in costs	45,000.00	M
Revised Operating Income	1,845,000.00	N=A+M
Current Residual Income	300,000.00	See L
Increase by 50%	150,000.00	O=L*50%
Target Residual Income	450,000.00	P=L+O
Required return	1,500,000.00	See K
Operating Income	1,845,000.00	See N
Residual Income	345,000.00	Q=N-K
Target Residual Income	450,000.00	See P
Residual Income should increase by	105,000.00	R=P-Q
Required rate of return	15%	See J
Decrease in total assets in 2020	700,000.00	S=R/J

Answer e

If Barkley Industries is really concerned that the focus on cost cutting, asset sales and no new investments will have an adverse long-run effect on PCD’s customers then it should give PCD opportunity to look for newer and better investment opportunities. Further it should also try to reduce costs as much as possible.