Question

Problem 10-18 Return on Investment (ROI) and Residual Income (LO10-1, LO10-2] "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: Sales Variable expenses Fixed expenses $2,000,000 60% of sales $640,000

Answer 1

1.ROI = Net Operating Income/Average Assets

= 800,000/4,000,000

= 20%

2.ROI of new product line = (2,000,000*40%-640,000)/1,000,000

= 16%

3.ROI when new line is added

= (800,000+160,000)/5,000,000

= 19.2%

4.Reject, since will reduce ROI

5.Because ROI of new line is higher than the overall ROI of the company

4.Residual Income = Net operating Income – Average operating assets*Minimum required rate of return

a.Office Products residual income = 800,000 – 4,000,000*12%

= $320,000

b.New Product Line added = 160,000 – 1,000,000*12%

= $40,000

c.Residual Income = 320,000 + 40,000 = $360,000

d.Accept as Residual Income has increased