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

Sales	$	21,200,000
Variable expenses		13,405,600
Contribution margin		7,794,400
Fixed expenses		5,950,000
Net operating income	$	1,844,400
Divisional average operating assets	$	4,240,000

The company had an overall return on investment (ROI) of 19.00% 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 $2,600,000. The cost and revenue characteristics of the new product line per year would be:

Sales	$9,100,000
Variable expenses	65% of sales
Fixed expenses	$2,538,900

Required:

1. Compute the Office Products Division’s ROI for this year.

2. Compute the Office Products Division’s ROI for the new product line by itself.

3. Compute the Office Products Division’s ROI for next year assuming that it performs the same as this year and adds the new product line.

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

5. Why do you suppose headquarters is anxious for the Office Products Division to add the new product line?

6. Suppose that the company’s minimum required rate of return on operating assets is 16% and that performance is evaluated using residual income.

a. Compute the Office Products Division’s residual income for this year.

b. Compute the Office Products Division’s residual income for the new product line by itself.

c. Compute the Office Products Division’s residual income for next year assuming that it performs the same as this year and adds the new product line.

d. Using the residual income approach, if you were in Dell Havasi’s position, would you accept or reject the new product line?

Answer 1

New Product Line 9,100,000 (5,915,000) (9100000*65%) 3,185,000 2,538,900 646,100 8.70% 29 Solution of 1st, 2nd and 3rd question 30 This Year New Product Line Next Year 31 Sales (A) 21,200,000 9,100,000 30,300,000 Sales 32 Net Operating Income (B) 1,844,400 646,100 2,490,500 Less Variable Expenses 33 Operating Assets (C) 4,240,000 2,600,000 6,840,000 Contribution Margin 34 Margin (B/A) = (D) 7.10% 8.22% Fixed Expenses 35 Turnover (A/C) = (E) 5.00 3.50 4.43 Operating Income 36 ROI (D *E) 43.50% 24.85% 36.41% 37 38 4.If you were in Dell Havasi's position, would you accept or reject the new product line? 39 40 Reject as ROI decreases 41 42 5. Why do you suppose headquarters is anxious for the Office Products Division to add the new product line? 43 44 Adding the new product line would increase Company's overall ROI. 45

46 Solution of 6th question a,b & c part 47 48 49 50 51 Operating Assets (A) Minimum required return(B) Minimum net operating Income (A*B) = C) Actual net operating income (D) Minimum net operating income (C) Residual Income (D-C) This Year 4,240,000 16% 678,400 1,844,400 678,400 1,166,000 New Product Line 2,600,000 16% 416,000 646,100 416,000 230,100 Next Year 6,840,000 16% 1,094,400 2,490,500 1,094,400 1,396,100 52 53 54 55 56 d) 57 Accept on the basis of Residual Income Approach. 58 59