Question

Problem 2: "I know headquarters wants us to add that new product line," said Fred Halloway, manager of Kirsi Products' East Division. "But I want to see the numbers before I make a move. Our division's return on investment has led the company for three years, and I don't want any letdown." Kirsi Products is a decentralized wholesaler with four autonomous divisions. The divisions are evaluated on the basis of ROI, with year-end bonuses given to divisional managers who have the highest ROL. Operating results for the East Division for the last year is give below: Kirsi Products - Last years' operating results for the East Division: $ 21,000,000 es Variable Expenses $ 13,400,000 $ 76,000,000 Contribution Margin Fixed Expenses $ 5,920,000 Net operating Income 1,680,000 Divisional operating assets 5,250,000 The company had an overall ROI of 18 % last ycar. The East Division has an opportunity to add a new product line that would require an investment of $3,000,000. The cost and the revenues for the new product line per year would be as follows: Additional information: Overall company ROI last year 18% Investment needed for new product line 3000000 Revenue characteristics for new product line: Sales 9000000 Variable expenses as a percent of sales Fixed expenses 65 % 2520000 1) Compute the ROI for last year and how it would be with the new product line. 2) If you were Fred Halloway, would you accept or reject the new product line and why? 3) Recompute assuming a minimum rate of return at 15 %. Now would you accept or reject the new product line?

Answer 1

1.

New product Line
Sales	9000000
Variable Costs (0.65*9000000)	5850000
Contribution	3150000
Fixed Costs	2520000
Net operating income	630000

	Present line	New Line	Total
Sales	21000000	9000000	30000000
Net operating income	1680000	630000	2310000
Operating assets	5250000	3000000	8250000
Margin	168/2100*100= 8%	7%	7.7%
Turnover	2100/525 = 4 times	3 times	3.64 times
ROI	168/525 = 32%	21%	28%

	Present	New	Total
Operating Assets	525000	3000000	8250000
Minimum return reqd	15%	15%	15%
Minimum Net operating Income	787500	450000	1237500

	Present	New	Total
Actual Net operating Income	1680000	630000	2310000
Min Net Operating Income	787500	450000	1237500
Residual Income	892500	180000	1072500

A)

ROI

168/525 = 32%

21%

28%

B) The overall ROI would fall from 32 to 28 percent by implementing the new line. However there will be additional operating income of 630000. Hence considering this, the new product line can be accepted

C) Since the residual income increases by 180000, the new product line can be accepted

(please comment in case of any query regarding the solution)