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 ROIs. Operating results for the company’s Office Products Division for this year are given below:

Sales	$	21,750,000
Variable expenses		13,731,600
Contribution margin		8,018,400
Fixed expenses		6,025,000
Net operating income	$	1,993,400
Divisional average operating assets	$	4,338,800

The company had an overall return on investment (ROI) of 18.00% 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 $2,126,350. The cost and revenue characteristics of the new product line per year would be:

Sales	$9,350,000
Variable expenses	65% of sales
Fixed expenses	$2,560,500

Required:

6. Suppose that the company’s minimum required rate of return on operating assets is 14% 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.

Answer 1

Solution 6a:

Computation of Residual income - Office Product division (Current year)
Particulars	Amount
Average investment	$4,338,800.00
target return	14%
Target income	$607,432.00
Operating income	$1,993,400.00
Target income	$607,432.00
Residual income	$1,385,968.00

Solution 6b:

Computation of Residual income - New product line
Particulars	Amount
Average investment	$2,126,350.00
target return	14%
Target income	$297,689.00
Operating income	$712,000.00
Target income	$297,689.00
Residual income	$414,311.00

Solution 6c:

Computation of Residual income - Office Product division (Next year)
Particulars	Amount
Average investment	$6,465,150.00
target return	14%
Target income	$905,121.00
Operating income	$2,705,400.00
Target income	$905,121.00
Residual income	$1,800,279.00