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 ROI. Operating results for the East Division for the last year is give below:

Kirsi Products - Last years' operating results for the East Division:
es	$    21,000,000
Variable Expenses	$    13,400,000
Contribution Margin	$    76,000,000
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 year. 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	65%
Fixed expenses	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?

Net operating Income for new product line:
Sales
Variable Exp
Contribution Margin
Fixed Expenses
Net operating Income
	Present	New Line	Total
Sales
Net operating income
Operating assets
Margin
Turnover
ROI
Recompute
Operating Assets
Minimum required return
Minimum net operating Income
Actual net operating Income
Minimum net operating income
Residual Income

Answer 1

ANSWER

AS per the given question,

Calculate Return on investment (ROI): Return on investment is the benefit received by investors for their investment S. No. Particulars Present New Line Total (1) Sales $21,000,000 $9,000,000 $30,000,000 (2) Net operating income $1,680,000 $630,000 $2,310,000 (3) Operating assets $5,250,000 $3,000,000 $8,250,000 (4) Margin (2) + (1) 8.0% 8.0% 7.0% 7.7% (5) Turnover (1) + (3) 4.00 3.00 3.64 (6) ROI (4) Ⓡ (5) 32% 21% 21% 28%

Working notes: Calculate net operating income: Deduct Variable expenses and fixed expenses to get net operating income Particulars Amount Sales $9,000,000 Variable expenses (65% * $9,000,000) 5,850,000 Contribution margin 3.150,000 Fixed expenses 2,520,000 Net operating income $630,000

2) The project should be rejected as it would reduce the division's overall rate of return

3)

Calculate residual income: Residual income is the difference of minimum operating income and actual net operating income. Residual income is calculated as follows: Particulars Present New Line Total Operating assets $5,250,000 $3,000,000 $8,250,000 Minimum required return x 15% 15% X 15% Minimum net operating income $787,500 $450,000 $1,237,500 Actual net operating income $1,680,000 $ 630,000 $2,310,000 Minimum net operating income (above) | 787,500 450,000 1,237,500 Residual income $ 892,500 $ 180,000 $1,072,500

The new product line should be accepted because it would increase the division's total residual income.

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