PROBLEM 11-21 Return on Investment (ROI) Analysis [L02l The contribution format

Question

PROBLEM 11-21 Return on Investment (ROI) Analysis [L02l
The contribution format income statement for Huerra Company for last year is given below:
Total Units
Sales 4,000,000 80.00
Variable Expenses 2,800,000 56.00
Contribution Margin 1,200,000 24.00
Fixed Expenses 840,000 16.80
Net Operating Income 360,000 7.20
Income Taxes@ 30% 108,000 2.16
Net Operating Income 252,000 5.04

The company had average operating assets of $2,000,000 during the year.
Required:
l. 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 $400,000.(The released funds are used to payoff short-term creditors.)
3. The company achieves a cost savings of $32,000 per year by using less costly materials.
4. The company issues bonds and uses the proceeds to purcbase $500,000 in machinery and equipment at the beginning of the period. Interest on the bonds is $60,000 per year. Sales remain unchanged. The new, more efficient equipment reduces production costs by $20,000 per year.
5. As a result of a more intense effort by salespeople, sales are increased by 20%; operating assets remain unchanged.
6. 0bsolete inventory carried on the books at a cost of $40,000 is scrapped and written off as a loss.
7. The company uses ~200,OOOof cash (received on accounts receivable) to repurchase and retire some of its common stock.

Explanation / Answer

Return on Investment (ROI) can be calculated using the DuPont formula. It uses the net profit margin and total asset turnover in the calculation of ROI. These measures indicate how effectively a company uses each dollar that is invested in assets to generate profits. It is fairly easy to learn how to calculate each of these components and the overall ROI. Steps : a. Locate the data for the "net profit after taxes" = $252,000 and "revenue" = $4M line items in the income statement. b. Divide the net profit after taxes number by the revenue number and multiply by 100 to calculate the net profit margin. Net profit margin indicates how many dollars in profit are made per each dollar that is produced in revenue. = 252,000*100/4M = 6.3% c. Locate the data for "total assets" = $2M in the balance sheet. Divide the revenue number = $4M by the total assets number and multiply by 100 to calculate asset turnover. Total asset turnover indicates the amount of sales that are generated for every dollar invested in assets. = 4M/2M = 2 d. Multiply net profit margin by the total asset turnover to calculate return on investment. RoI = 6.3%*2 = 12.6% 2. Inventory reduced by $400,000 & used to pay-off short term creditor. Now recall that WOrking Capital = Current Assets - Current Liabiliies. So effect of above is to reduce the Working Capital by $400,000 Operating Assets = Working capital + Fxed assets = $2M Since woring capital has reduced by $400,000, New Operating assets = $2M-$400,000 = $1.6M Steps for ROI calculation: a. Locate the data for the "net profit after taxes" = $252,000 and "revenue" = $4M line items in the income statement. b. Divide the net profit after taxes number by the revenue number and multiply by 100 to calculate the net profit margin. Net profit margin indicates how many dollars in profit are made per each dollar that is produced in revenue. = 252,000*100/4M = 6.3% c. Locate the data for "total assets" = $1.6M in the balance sheet. Divide the revenue number = $4M by the total assets number and multiply by 100 to calculate asset turnover. Total asset turnover indicates the amount of sales that are generated for every dollar invested in assets. = 4M/1.6M = 2.5 d. Multiply net profit margin by the total asset turnover to calculate return on investment. RoI = 6.3%*2.5 = 15.75% 3. Cost saving of $32000. This reduces COGS by $32000. SO Net Income increases by $32000 to (252000+32000) = 284000 Steps for ROI calculation: a. "net profit after taxes" = $284,000 and "revenue" = $4M line items in the income statement. b. Divide the net profit after taxes number by the revenue number and multiply by 100 to calculate the net profit margin. Net profit margin indicates how many dollars in profit are made per each dollar that is produced in revenue. = 284,000*100/4M = 7.1% c. Locate the data for "total assets" = $2M in the balance sheet. Divide the revenue number = $4M by the total assets number and multiply by 100 to calculate asset turnover. Total asset turnover indicates the amount of sales that are generated for every dollar invested in assets. = 4M/2M = 2 d. Multiply net profit margin by the total asset turnover to calculate return on investment. RoI = 7.1%*2 = 14.2% 4. Bond Int = 60000. Tax Rate = 30%. Redn in Production cost by $20000 increases Operating Inc to (360,000+20000) = 380,000 Less Int on Bonds = (380,000 - 60000) = 320,000 Less Tax @30% = 30%*320,000 = 96000 So Net Operating Income = 320,000-96000 = 224,000 Steps for ROI calculation: a. "net profit after taxes" = $224,000 and "revenue" = $4M line items in the income statement. b. Divide the net profit after taxes number by the revenue number and multiply by 100 to calculate the net profit margin. Net profit margin indicates how many dollars in profit are made per each dollar that is produced in revenue. = 224,000*100/4M = 5.6% c. Locate the data for "total assets" = $2M in the balance sheet. Divide the revenue number = $4M by the total assets number and multiply by 100 to calculate asset turnover. Total asset turnover indicates the amount of sales that are generated for every dollar invested in assets. = 4M/2M = 2 d. Multiply net profit margin by the total asset turnover to calculate return on investment. RoI = 5.6%*2 = 11.2% 5. Sales inc by 20%. Sales units= 4,000,000/80 = 50,000. So new sales vol = 1.20*50,000 = 60,000 So Sales Revenue = 60000*$80 = $4,800,000 = $4.8M New Variable Expenses 1.2*2,800,000 = 3,360,000 = $3.36M Contribution Margin 1,440,000 = 1.44M Fixed Expenses 840,000 Operating Income 600,000 Income Taxes@ 30% 180,000 Net Operating Income 420,000 Steps for ROI calculation: a. "net profit after taxes" = $420,000 and "revenue" = $4.8M line items in the income statement. b. Divide the net profit after taxes number by the revenue number and multiply by 100 to calculate the net profit margin. = 420,000*100/4.8M = 8.75% c. Locate the data for "total assets" = $2M in the balance sheet. Divide the revenue number = $4.8M by the total assets number and multiply by 100 to calculate asset turnover. = 4.8M/2M = 2.4 d. Multiply net profit margin by the total asset turnover to calculate return on investment. RoI = 8.75%*2.4 = 21% 6. Inventry of $40,000 written-off. This reduces Working capital by $40,000. So Operating assets reduce by $40000 ie Opearting assets = (2,000,000-40,000) = $1.96M As Inevntory is written off, this amountof $40,000 is also booked against Gross Income ie (360,000 - 40,000) = 320,000 Less 30% Tax = 96000 Net Income = 320,000-96000 = 224,000 Steps for ROI calculation: a. "net profit after taxes" = $224,000 and "revenue" = $4M line items in the income statement. b. Divide the net profit after taxes number by the revenue number and multiply by 100 to calculate the net profit margin. = 224,000*100/4M = 5.6% c. Locate the data for "total assets" = $1.96M in the balance sheet. Divide the revenue number = $4M by the total assets number and multiply by 100 to calculate asset turnover. = 4M/1.96M = 2.04 d. Multiply net profit margin by the total asset turnover to calculate return on investment. RoI = 5.6%*2.04 =11.43% 7. Cash Reduced by $200K. So Wrking Capital will reduce by $200K. That is Operating assets will reduce by $200K as in 2 above. SO New Operating assets = $2M-$200K = $1.8M Steps for ROI calculation: a. "net profit after taxes" = $252,000 and "revenue" = $4M line items in the income statement. b. Divide the net profit after taxes number by the revenue number and multiply by 100 to calculate the net profit margin. = 252,000*100/4M = 6.3% c. Locate the data for "total assets" = $1.8M in the balance sheet. Divide the revenue number = $4M by the total assets number and multiply by 100 to calculate asset turnover. = 4M/1.8M = 2.22 d. Multiply net profit margin by the total asset turnover to calculate return on investment. RoI = 6.3%*2.22 =13.98%

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