Question

"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 ROls. Operating results for the company's Office Products Division for this year are given below: Sales Variable expenses Contribution margin Fixed expenses Net operating income Divisional average operating assets $ 22,600,000 14,157,400 8, 442,600 6,160,000 $ 2,282,600 $ 4,520,000 The company had an overall return on investment (ROI) of 16.00% 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 $2,450,000. The cost and revenue characteristics of the new product line per year would be: Sales Variable expenses Fixed expenses $9,800,000 65% of sales $2,595,000 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 13% 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?

Can someone please explain part 6 of the question.

Answer 1

1. Residual Income means = Operating Income - (Minimum Required rate of Return * Average Operating Assets)

2. Please refer the solution provided. For any Queries please comment. All the part have been solved. IF any calculation are not clear please comment we will surely help you with the same. Thank you !

Part - 6 (a) Sales Variable Expenses Contribution Margin Fixed Expense Net operating expense 22600000 14157400 8442600 6160000 2282600 Divisional Average operating assets Minimum Required rate of Return 4520000 13% Office product Division Residual Income = Operating operating Divisional Average Income - Minimum Required rate expense operating assets Minimum Required rate of Return of Return * Average Operating 2282600 4520000 13% Assets 1695000

Part - 6 (b) Sales Variable Expenses Contribution Margin Fixed Expense Net operating expense 9800000 6370000 65% of sales 3430000 2595000 835000 Divisional Average operating assets Minimum Required rate of Return 2450000 13% New product Division Residual Income - Operating operating Divisional Average Income - Minimum Required rate expense operating assets Minimum Required rate of Return of Return * Average Operating 835000 2450000 13% Assets 516500

Part - 6 (C) Consolidated of Office Division + New Product Line Sales 32400000 Variable Expenses 20527400 Contribution Margin 11872600 Fixed Expense 8755000 Net operating expense 3117600 Office Division Sales Variable Expenses Contribution Margin Fixed Expense Net operating expense 22600000 14157400 8442600 6160000 2282600 New Product Line Sales Variable Expenses Contribution Margin Fixed Expense Net operating expense 9800000 6370000 3430000 2595000 835000 6970000 Divisional Average operating assets 4520000 Divisional Average operating assets 2450000 Divisional Average operating assets Minimum Required rate of Return 13% Consolidated of Office Division + New Product Line Residual Income for next year Residual Income = Operating Income - Minimum Required rate of Return * Average Operating Assets operating Divisional Average expense operating assets Minimum Required rate of Return 3117600 6970000 13% 2211500 Part - 6 (d) Dell Havasi should accept the New product line Because --- a) New product line has positive Residual Income of 516500 b) Further consolidated Residual income would also increase from 1695000 to 2211500