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 ha the highest ROls. Operating results for the company's Office Products Division for this year are given below: es Sales Variable expenses Contribution margin Fixed expenses Net operating income $10,000,e00 6,000,000 4,000,000 3,200,008 800,ee0 $ Divisional average operating assets $ 4,000,eee The company had an overall return on investment (ROI) of 15% 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 $1,000,000. The cost and revenue characteristics of the new product line per year would be: Sales Variable expenses Fixed expenses $2,000,000 60% of sales $640,eee Required: 1. Compute the Office Products Division's ROI for this year Prev 3 of 3 levt

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
	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	2.50	2.00	2.40
ROI	20.00%	16.00%	19.20%
1
ROI for this year = 20%
2
ROI for new product line by itself = 16%
3
ROI for next year = 19.2%
4
Reject, as ROI decreases
5
Adding the new product line would increase company's overall ROI
6
	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
a
Residual income for this year = $320000
b
Residual income for new product line =$40000
c
Residual income for next year = $360000
d
Accept, as residual income increases