Question

Problem 11-18 Return on Investment (ROI) and Residual Income [LO11-1, LO11-2] "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 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 $ 22,235,000 13,981,800 8,253,200 6,100,000 $ 2,153,200 $ 4,625,000 The company had an overall return on investment (ROI) of 17.00% 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 $2,400,000. The cost and revenue characteristics of the new product line per year would be: Sales Variable expenses Fixed expenses $9,600,000 65% of sales $2,582,400 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 14% 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

Net product line net operating income = 9600000*(1-65%)-2582400= $777600
Margin = Net operating income/Sales
Turnover = Sales/Operating assets
ROI = Margin*Turnover
	Present	New line	Total
Sales	22235000	9600000	31835000
Net operating income	2153200	777600	2930800
Operating assets	4625000	2400000	7025000
Margin	9.68%	8.10%	9.21%
Turnover	4.81	4.00	4.53
ROI	46.56%	32.40%	41.72%
1
ROI for this year = 46.56%
2
ROI for new product line by itself = 32.40%
3
ROI for next year = 41.72%
4
Reject, as ROI decreases
5
Adding the new product line would increase company's overall ROI
6
	Present	New line	Total
Operating assets	4625000	2400000	7025000
Minimum required return	14%	14%	14%
Minimum Net operating income	647500	336000	983500
Actual Net operating income	2153200	777600	2930800
Minimum Net operating income	647500	336000	983500
Residual income	1505700	441600	1947300
a
Residual income for this year = 1505700
b
Residual income for the new product line = 441600
c
Residual income for next year = 1947300
d
Accept, as residual income increases