Question

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 $ 21,200,000 13,405,600 7,794,400 5,950,000 $ 1,844,400 $ 4,240,000 The company had an overall return on investment (ROI) of 19.00% 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 $2,600,000. The cost and revenue characteristics of the new product line per year would be: Sales Variable expenses Fixed expenses $9,100,000 65% of sales $2,538,900 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 16% 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? Complete this question by entering your answers in the tabs below.

Answer 1

1) ROI= Net operating income/Average operating assets

= $1844400*100/4240000= 43.5%

2) Calculation of net operating income when the new product is added

Sales	$9100000
Less: Variable cost (9100000*65%)	-5915000
Contribution	3185000
Less: Fixed expenses	-2538900
Net operating income	$646100

ROI= Net operating income/Average operating assets

= $646100*100/2600000= 24.85%

3) New average operating assets= $4240000+2600000= $6840000

New operating income= $1844400+646100= $2490500

ROI= $2490500*100/6840000= 36.41%

4) No, the company should reject the new product as if the new product line is added the ROI of the company will decreases.

5) Headquarters is anxious to add the new product line because it will increase the overall ROI of the company.

6-a) Residual income= Net income- (Average operating assets*Minimum rate of return)

= $1844400-($4240000*16%)= $1166000

b) Residual income of new product= $646100-($2600000*16%)= $230100

c) New operating income= $1844400+646100= $2490500

New average operating assets= $4240000+2600000= $6840000

Total= $2490500-($6840000*16%)= $1396100

d) Yes, the company should accept the new product line as when the new product line is added the residual income of the company will increases. Therefore, it should accept the new product line.