Question

Scenario:
Wellness Pharmaceuticals is a small firm specializing in new products. It is organized into two divisions, based on the products they produce. BD Division is smaller and the life of the products it produces tend to be shorter than those produced by the larger PM Division. Selected financial data for the past year is shown below. Divisional investment is as of the beginning of the year. Wellness Pharmaceuticals uses a 9 percent cost of capital and beginning-of-the-year investment when computing ROI and residual income. Ignore income taxes.e building. The following information (in $000s) appears in the accounting records for last year:
	BD Division	PM Division
Allocated Corporate Overhead	$660	$1,980
Cost of Goods Sold	3,520	7,700
Divisional Investment	9,900	88,000
Research and Development	2,200	3,960
Sales	8,800	2,200
SG&A	770	1,683
REQUIRED
1. Compute divisional income for the two divisions.
2. Calculate the operating margin, which is equivalent to the return on sales, for the two divisions.
3. Calculate ROI for the two divisions.
4. Compute residual income for the two divisions.
5. Assess the financial performance of the two divisions based on your analysis.

Answer 1

1) Calculation of Divisional Income for each Division (Amounts in $'000)

	BD Division	PM Division
Sales	8,800	2,200
Cost of goods sold	(3,520)	(7,700)
Gross Profit	5,280	(5,500)
Allocated Corporate Overhead	(660)	(1,980)
Research and Development cost	(2,200)	(3,960)
Selling and Administrative cost	(770)	(1,683)
Divisional Income/(Loss)	1,650	(13,123)

2) Calculation of Operating Margin (Amounts in $)

	BD Division	PM Division
Sales (A)	8,800	2,200
Divisional Income/(Loss) (B)	1,650	(13,123)
Operating Margin (A/B)*100	18.75%	-596.50%

3) Calculation of Return on Investment (ROI)   (Amounts in $)

	BD Division	PM Division
Divisional Income/(Loss) (C)	1,650	(13,123)
Divisional Investment (D)	9,900	88,000
ROI (C/D*100)	16.67%	-14.91%

4) Calculation of Residual Income for Two divisions   (Amounts in $)

	BD Division	PM Division
Divisional Investment (a)	9,900	88,000
Cost of capital (b)	9%	9%
Minimum Divisional Income (c=a*b)	891	7,920
Actual Divisional Income/(Loss) (d)	1,650	(13,123)
Residual Income (d-c)	759	(21,043)

5) Based on above analysis, the financial performance of PM division is not good as its divisional income, ROI, operating margin and residual income are negative. Whereas on the other hand, the financial performance of BD Division is satisfactory.