Question

Problem 10-20 Return on Investment (ROI) Analysis [LO10-1]

The contribution format income statement for Huerra Company for last year is given below:

	Total		Unit
Sales	$	4,000,000	$	80.00
Variable expenses		2,800,000		56.00
Contribution margin		1,200,000		24.00
Fixed expenses		840,000		16.80
Net operating income		360,000		7.20
Income taxes @ 30%		108,000		2.16
Net income	$	252,000	$	5.04

The company had average operating assets of $2,000,000 during the year.

Required:

1. Compute the company’s return on investment (ROI) for the period using the ROI formula stated in terms of margin and turnover.

For each of the following questions, indicate whether the margin and turnover will increase, decrease, or remain unchanged as a result of the events described, and then compute the new ROI figure. Consider each question separately, starting in each case from the data used to compute the original ROI in (1) above.

2. Using Lean Production, the company is able to reduce the average level of inventory by $400,000. (The released funds are used to pay off short-term creditors.)

3. The company achieves a cost savings of $32,000 per year by using less costly materials.

4. The company issues bonds and uses the proceeds to purchase machinery and equipment that increases average operating assets by $500,000. Interest on the bonds is $60,000 per year. Sales remain unchanged. The new, more efficient equipment reduces production costs by $20,000 per year.

5. As a result of a more intense effort by salespeople, sales are increased by 20%; operating assets remain unchanged.

6. At the beginning of the year, obsolete inventory carried on the books at a cost of $40,000 is scrapped and written off as a loss.

7. At the beginning of the year, the company uses $200,000 of cash (received on accounts receivable) to repurchase and retire some of its common stock.

Answer 1

ANSWER

Huerra Company 1. Compute the company's return on investment (ROI) for the period using the ROI formula stated in terms of margin and turnover. Margin Net Operating Income / Sales = 360000 / 4000000 = 9% Turnover Sales / Average Operating Assets = 4000000 / 2000000 = 2 ROI Margin x Turnover =9% x 2 = 18% 2. Using Lean Production, the company is able to reduce the average level of inventory by $400,000. Margin 9% Turnover Sales / Average Operating Assets = 4000000 / 1600000 = 2.5 ROI Margin x Turnover = 9% x 2.5 = 22.5% 3. The company achieves a cost savings of $32,000 per year by using less costly materials. Margin Net Operating Income / Sales = 392000 / 4000000 = 9.8% Turnover Sales / Average Operating Assets = 4000000 / 2000000 = 2 ROI Margin x Turnover = 9.8% x 2 = 19.6% 4. The company issues bonds and uses the process to purchase $500 000 in machinery and equipment at the beginning of the period .Interest on the bonds is $60 000 per year.Sales remain unchanged. The new, more efficient equipment reduces production costs by $20 000 per year. Margin Net Operating Income / Sales = 380000 / 4000000 = 9.5% Turnover Sales / Average Operating Assets = 4000000 / 2500000 = 1.6 ROI Margin x Turnover = 9.5% x 1.6 = 15.2% Net operating Income = 360000 +20000 = 320000

5. Sales are increased by 20%; operating assets remain unchanged. Margin Net Operating Income / Sales = 600000 / 4800000 = 12.5% Turnover Sales / Average Operating Assets = 4800000 / 2000000 = 2.4 ROI Margin x Turnover = 12.5% x 2.4 = 30% Net Operating Income = Contribution x 1.2 = 1440000 - 840000 = 600000 Sales = 4000000 x 1.2 = 4800000 6. Obsolete inventory carried on the books at a cost of $40,000 is scrapped and written off as a loss. Margin Net Operating Income / Sales = 320000 / 4000000 = 8% Turnover Sales / Average Operating Assets = 4000000 / 1960000 = 2.04 ROI Margin x Turnover = 8% x 2.04 = 16.32% Net Operating Income = 360000 - 40000 = 320000 Operating Assets = 2000000 - 40000 = 1960000 7. The company uses $200,000 of cash (received on accounts receivable) to repurchase and retire some of its common stock. Margin Net Operating Income / Sales = 360000 / 4000000 = 9% Turnover Sales / Average Operating Assets = 4000000 / 1800000 = 2.22 ROI Margin x Turnover = 9% x 2.22 = 19.68% Operating Assets = 2000000 - 200000 = 1800000

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