Question

The contribution format income statement for Huerra Company for last year is given below:

	Total		Unit
Sales	$	992,000	$	49.60
Variable expenses		595,200		29.76
Contribution margin		396,800		19.84
Fixed expenses		314,800		15.74
Net operating income		82,000		4.10
Income taxes @ 40%		32,800		1.64
Net income	$	49,200	$	2.46

The company had average operating assets of $495,000 during the year.

Required:

1. Compute the company’s return on investment (ROI) for the period using the ROI formula stated in terms of margin and turnover.

For each of the following questions, indicate whether the margin and turnover will increase, decrease, or remain unchanged as a result of the events described, and then compute the new ROI figure. Consider each question separately, starting in each case from the data used to compute the original ROI in (1) above.

2. Using Lean Production, the company is able to reduce the average level of inventory by $104,000. (The released funds are used to pay off short-term creditors.)

3. The company achieves a cost savings of $6,000 per year by using less costly materials.

4. The company issues bonds and uses the proceeds to purchase machinery and equipment that increases average operating assets by $126,000. Interest on the bonds is $13,000 per year. Sales remain unchanged. The new, more efficient equipment reduces production costs by $7,000 per year.

5. As a result of a more intense effort by sales people, sales are increased by 25%; operating assets remain unchanged.

6. At the beginning of the year, obsolete inventory carried on the books at a cost of $19,000 is scrapped and written off as a loss.

7. At the beginning of the year, the company uses $184,000 of cash (received on accounts receivable) to repurchase and retire some of its common stock.

Answer 1

1. Formula for ROI is Net Profit/ Total assets

Total Profit of the company is $49200

Total operating assets $495000

Thus ROI is 49200/495000 = 9.93%

2. If the inventory will reduce and because of which the creditors of the company will also reduce then it will mean that both assets and liability will reduce and it wont have any impact on the net assets of the company and thus ROI of the company will not change it will remain same as 9.93%

3. If the Variable cost will decline by $6000 then profit will also increase by $6000 i.e. new profit of the company is $55200 and due to rise in the profit of the company. ROI will increase, new ROI of the company is 55200/495000 = 11.1%

4. In this case average assets will increase by $ 126000, thus new assets of the company is $ 621000. Now Interest expenses will be there of $13000 which will save the outflow of tax thus net expenses of the company will be 13000*.6 = $ 7800 and now due to new machine there will be saving in cost by $ 7000. Thus new increase in the expenses is $ 800 and because of this profit will reduce by $ 800 and new profit is $ 48400 . Thus ROI will fall and new ROI is 7.78%

5. If sales will increase by 25% then variable cost will also increase and due to which the contribution margin will also increase by 25%. New Contribution margin is $396800*1.25 = $ 496000. Total fixed cost is 314800 and tax rate is 40% thus net profit of the company is $108720. Due to rise in the profit ROI of the company will also increase. New ROI of the company is 17.5%

6. Since the assets is reduced by $19000 overall assets will fall be $19000 and new assets value is $ 476000 profit will not change since due to decline in the base overall ROI will rise. New ROI is 10.3%

7. In the case operating assets is used to reduce the non operating liability thus overall assets will fall new operating assets of the company is $ 311,000. Now there is no change in the profit of the company. Thus due to decline in the base overall ROI will increase and new ROI of the company is 15.8%

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