Question

CASE 2 Your friend Tanvier (who went to school with you at Yorkville University) just got a job at XYZ corp, and has asked for your help in understanding how his bonus will be determined. Tanvier was a very poor student as he rarely attended class and often plagiarized on his assignments and exams. He knows that you were a very good student who always behaved ethically and never cheated on any case studies. Last year XYZ Corp had operating income of $6,500,000 and sales of $21,000,000. The Balance sheet showed liabilities of $12,000,000 and owners equity of $6,000,000. You believe that Tanvier will soon be fired from his job as he is very weak in Managerial Accounting, and never put in any effort to understand the subject. He continues to behave inappropriately by not showing up to work and lying to his boss. Tanvier's bonus will be based on ROI, which they calculate as operating income over assets. If Tanvier had regularly attended his classes and would not have cheated on his case studies, he would have known how to do these calculations, unfortunately he is now confused. Lucky for him, you were a very good student while at Yorkville University who always behaved in an honest and ethical manner, so he has asked for your help. Next year XYZ corp wants Rolto be 40% and has forecasted sales to be $21,000,000. Tanvier has asked you to help him answer the following questions 1. What is XYZ corp Return on Sales and Return on Investment 2. How much would XYZ have to cut costs this year in order to achieve 40% ROI. (assume Assets remain the same) 3. How much would XYZ have to reduce assets this year to achieve 40% ROI. (assume operating income remains the same) 4. What was XYZ's residual income last year considering a ROI of 35% 5. XYZ wants to increase residual income to 35% next year. It can cut costs by $50,000 next year how much would liabilities and/or owners equity need to decrease by next year?

Answer 1

The following details are available,

1.Operating Income - $6,500,000

2.Sales - $21,000,000

3.Liabilities - $12,000,000

4.Owners Equity - $6,000,000

We are required to finf out the followings,

1.

a) Return on sales

Return on sales = (Operating Income/Sales)*100

= ($6,500,000/$21,000,000)*100

= 30.95%

b) Return on Investment

Return on Investment (ROI) = (Operating Income/Assets)*100

Assets = Owners Equity + Liabilities

= $6,000,000 + $12,000,000

Assets = $18,000,000

ROI = (Operating Income/Assets)*100

= ($6,500,000/$18,000,000)*100

= 36.11%

2.

If ROI is 40% and Assets remains the same,

ROI = $18,000,000*40%

= $7,200,000

Current Return on Investment is $6,500,000. In order to achieve 40% return on investment ie.$7,200,000, XYZ corp has to cut the cost by $7,000,000 ($7,200,000 - $6,500,000).

3.

If ROI is 40% and Operational Income remains the same,

ROI = (Operating Income/Assets)*100

40% = ($6,500,000/Assets)*100

Therefor, Assets = (Operating income/ROI) *100

= ($6,500,000/40) * 100

= $16,250,000

4.

Residual income is the amount of profit over and above the required return.

Residual income = Income - (Assets * ROI)

= $6,500,000 - ($18,000,000 * 35%)

= $6,500,000 - $6,300,000

= $200,000

5.

Residual income for next year = Current year residual income * 135%

= $200,000 * 135%

= $270,000

Residual Income = Income - (Assets * ROI)

if Return on Investment for next year would be 40 %, and the company can cut the cost by $50,000,

Income = ($18,000,000 * 40%) + $50,000

= $7,250,000

Residual income = Income - (Assets * ROI)

Suppose Assets = x,

$270,000 = $7,250,000 - ( x * 40%)

0.4x = $7,250,000 + $270,000

0.4x = $7,520,000

x =  $7,520,000 / 0.4

Assets, x = $18,800,000

Being assets = Owners equity + Liability,

If assets is to be increased to $18,800,000, The owners equity+Liability should be decreased by $80,000.