Question

In 2018, the Mandarin Division of Key Products Corporation generated an operating income of $3,000,000 from $20,000,000 of sales revenues and using assets worth $15,000,000.

Mandarin managers are evaluated and rewarded on the basis of ROI. Key Products Corporation expects its division to increase ROI each year.

The year 2019 appears to be a difficult year for Mandarin. Mandarin Division had planned new investments to improve quality but, in view of poor economic conditions, has postponed the investment. ROI for 2018 was certain to decrease had Mandarin made the investment. Management is now considering ways to meet its target ROI of 22% for next year. It anticipates revenue to be steady at $20,000,000.

Required

1. Calculate Mandarin Division’s ROI for 2018.
2. By how much would Mandarin have to cut costs in 2019 to achieve its target ROI of 22% in 2019, assuming no change in total assets between 2018 and 2019?
3. By how much would Mandarin have to decrease total assets in 2019 to achieve its target ROI of 22% in 2019, assuming no change in operating income between 2018 and 2019?

Answer 1

Requirement 1: Compute division’s return on investment (ROI) for the year 2018 as follows

Return on investment = Operating income ÷ Total assets

                                    = $3,000,000 ÷ $15,000,000

                                    = 20%

Requirement 2: Compute the reduction in cost as follows

Operating income in 2019       = Total assets × Return on investment

                                                = $15,000,000 × 22%

                                                = $3,300,000

Required reduction in cost      = Operating income 2019 − Operating income in 2018

                                                = $3,300,000 − $3,000,000

                                                = $300,000

Requirement 3: Compute the reduction in assets as follows

Required assets to earn 22%   = Operating income ÷ Return on investment

                                                = $3,000,000 ÷ 22%

                                                = $13,636,364

Required decrease in total assets      = $15,000,000 − $13,636,364

                                                            = $1,363,636