Question

Problem 11-18 Return on Investment (ROI) and Residual Income [LO11-1, LO11-2]

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

Sales	$	10,000,000
Variable expenses		6,000,000
Contribution margin		4,000,000
Fixed expenses		3,200,000
Net operating income	$	800,000
Divisional operating assets	$	4,000,000

The company had an overall return on investment (ROI) of 15% last year (considering all divisions). The Office Products Division has an opportunity to add a new product line that would require an additional investment in operating assets of $1,000,000. The cost and revenue characteristics of the new product line per year would be:

Sales	$2,000,000
Variable expenses	60% of sales
Fixed expenses	$640,000

Required:
1.	Compute the Office Products Division’s ROI for the most recent year; also compute the ROI as it would appear if the new product line is added. (Round the "Turnover", "ROI" answers to 1 decimal place.)

        

2.	If you were in Dell Havasi’s position, would you accept or reject the new product line?
	Accept Reject

3.	Why do you suppose headquarters is anxious for the Office Products Division to add the new product line?
	Adding the new line would increase the company's overall ROI. Adding the new line would decrease the company's overall ROI.

4.	Suppose that the company’s minimum required rate of return on operating assets is 12% and that performance is evaluated using residual income.

a.	Compute the Office Products Division’s residual income for the most recent year; also compute the residual income as it would appear if the new product line is added.

             

b.	Under these circumstances, if you were in Dell Havasi’s position, would you accept or reject the new product line?
	Accept Reject

Answer 1

Net product line net operating income = 2000000*(1-60%)-640000= $160000
Margin = Net operating income/Sales
Turnover = Sales/Operating assets
ROI = Margin*Turnover
1
	Present	New line	Total
Sales	10000000	2000000	12000000
Net operating income	800000	160000	960000
Operating assets	4000000	1000000	5000000
Margin	8.00%	8.00%	8.00%
Turnover	2.5	2.0	2.4
ROI	20.0%	16.0%	19.2%
2
Reject, as ROI decreases
3
Adding the new product line would increase company's overall ROI
4a
	Present	New line	Total
Operating assets	4000000	1000000	5000000
Minimum required return	12%	12%	12%
Minimum Net operating income	480000	120000	600000
Actual Net operating income	800000	160000	960000
Minimum Net operating income	480000	120000	600000
Residual income	320000	40000	360000
b
Accept, as residual income increases