Question

Problem 11-20 Return on Investment and Residual Income (LO3, LO4) Faced with headquarters' desire to add a new product line, Stefan Grenier, manager of Bilti Products' East Division, felt that he had to see the numbers before he made a move. His division's ROI has led the company for three years, and he doesn't want any letdown. Bilti Products is a decentralized wholesaler with four autonomous divisions. The divisions are evaluated on the basis of ROI, with year-end bonuses given to divisional managers who have the highest ROI. Operating results for the company's East Division for last year are given below: Sales Variable expenses $ 28,000,000 14,300,000 Contribution margin Fixed expenses 13,700,000 11,740,000 Operating income $ 1,960,000 Divisional operating assets $ 7,000,000 The company had an overall ROI of 12% last year (considering all divisions). The new product line that headquarters wants Grenier's East Division to add would require an investment of $4,000,000. The cost and revenue characteristics of the new product line per year would be as follows: Sales Variable expenses Fixed expenses $ 12,000,000 60% of sales $ 4,200,000 Required: 1. Compute the East Division's ROI for last year, also compute the ROI as it would appear if the new product line were added. (Do not round intermediate calculations.) Total Present 28 % New Line 15% ROI 2. If you were in Grenier's position, would you accept or reject the new product line? Accept • Reject

Answer 1

Net product line net operating income = 12000000*(1-60%)-4200000= $600000
Margin = Net operating income/Sales
Turnover = Sales/Operating assets
ROI = Margin*Turnover
	Present	New line	Total
Sales	28000000	12000000	40000000
Net operating income	1960000	600000	2560000
Operating assets	7000000	4000000	11000000
Margin	7.00%	5.00%	6.40%
Turnover	4.00	3.00	3.64
ROI	28.00%	15.00%	23.27% or 23%
2
Reject, as ROI decreases
3
Adding the new product line would increase company's overall ROI
4
	Present	New line	Total
Operating assets	7000000	4000000	11000000
X Minimum required return	10%	10%	10%
Minimum Net operating income	700000	400000	1100000
Actual Net operating income	1960000	600000	2560000
Less :Minimum Net operating income	700000	400000	1100000
Residual income	1260000	200000	1460000
b
Accept, as residual income increases