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 $ 22,000,000 Variable expenses 13,500,000 Contribution margin 8,500,000 Fixed expenses 6,000,000 Net operating income $ 2,500,000 Divisional average operating assets $ 4,443,500 The company had an overall return on investment (ROI) of 16.00% 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 $2,289,300. The cost and revenue characteristics of the new product line per year would be: Sales $9,155,000 Variable expenses 65% of sales Fixed expenses $2,543,950 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

Solution 1:

Office Products Division’s ROI for this year = Net Operating income / Average operating assets = $2,500,000 / $4,443,500 = 56.26%

Solution 2:

Operating income from new product line = ($9,155,000*35%) - $2,543,950 = $660,300

Average operating assets for new product line = $2,289,300

ROI offered by new product line = $660,300 / $2,289,300 = 28.84%

Solution 3:

Total operating income for office product division for next year after adding new product line = $2,500,000 + $660,300 = $3,160,300

Average operating assets = $4,443,500 + $2,289,300 = $6,732,800

Office Products Division’s ROI for next year = $3,160,300 / $6,732,800 = 46.94%

Solution 4:

I will not accept new product line as overall ROI of the division is decreasing.

solution 5:

Headquarters is anxious for the Office Products Division to add the new product line because ROI offered by new product line is higher than minimum required return of the company.

Solution 6a:

Office Products Division’s residual income for this year = operating income - Minimum required return

= $2,500,000 - ($4,443,500*13%) = $1,922,345

Solution 6b:

Office Products Division’s residual income for the new product line by itself = operating income - Minimum required return

= $660,300 - ($2,289,300*13%) = $362,691

Solution 6c:

Office Products Division’s residual income for next year = $1,922,345 + $362,691 = $2,285,036

Solution 6d:

As residual income is increasing, therefore i will accept new product line.