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 ROls. Operating results for the company's Office Products Division for this year are given below: Sales Variable expenses Contribution margin Fixed expenses Net operating income Divisional average operating assets $ 10.000.000 6.000.000 4,000,000 3.200.000 $ 800.000 $ 4.000.000 The company had an overall return on investment (ROI) of 15% 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 $1,000,000. The cost and revenue characteristics of the new product line per year would be: $2,000,000 Variable expenses Fixed expenses $640.000 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 12% 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

1. Current year ROI for Office Products Division = Net operating income /Divisional average operating assets = $800000/$4000000 = 20.0%

2. ROI for new product-line: 16.0%

Net operating income = Sales - Variable expenses - Fixed expenses = $2000000 - (60% x $2000000) - $640000 = $160000

Average net operating assets = $1000000

ROI = $160000/$1000000 = 16%

3. ROI for Office Products Division with new product line: 19.2%

Total net operating income = $800000 + $160000 = $960000

Average operating assets = $4000000 + $1000000 = $5000000

ROI = $960000/$5000000 = 19.2%

4. Reject

Since it would bring down the divisions ROI from 20% to 19.2%

5. Adding the new line would increase the company's overall ROI.

Headquarters is anxious to add the new product line since it has a ROI of 16% which is higher than the current overall ROI of 15%.

6.

	Invested Assets	Income from Operations	Minimum Rate of Return	Minimum Acceptable Income from Operations	Residual Income
	(A)	(B)	(C)	(D) = (A) x (C)	(E) = (B) - (D)
a.	4000000	800000	12%	480000	320000
b.	1000000	160000	12%	120000	40000
c.	5000000	960000	12%	600000	360000

6d. Accept

Since residual income with new product line would be higher at $360000 than the current residual income of $320000.