“I know headquarters wants us to add that new product line,” said Dell Havasi, m
ID: 2459756 • Letter: #
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 ROIs. Operating results for the company’s Office Products Division for the most recent year are given below:
The company had an overall return on investment (ROI) of 18.00% last year (considering all divisions). The Office Products Division has an opportunity to add a new product line that would require an additional investment in operating assets of $2,430,600. The cost and revenue characteristics of the new product line per year would be:
Compute the Office Products Division’s ROI for the most recent year; also compute the ROI as it would appear if the new product line is added. (Round the "Margin", "Turnover" and "ROI" answers to 2 decimal places.) PRESENT NEW LINE TOTAL
SALES
Net operating income
margin(%)
Turnover
ROI(%)
If you were in Dell Havasi’s position, would you accept or reject the new product line?
Why do you suppose headquarters is anxious for the Office Products Division to add the new product line?
Suppose that the company’s minimum required rate of return on operating assets is 15.00% and that performance is evaluated using residual income.
Compute the Office Products Division’s residual income for the most recent year; also compute the residual income as it would appear if the new product line is added.
Present new line total
operating assets
minimum required reutrn(%)
minimum net operating income
actual net operating income
minumum net operating income
residual income
Under these circumstances, if you were in Dell Havasi’s position, would you accept or reject the new product line?
“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.”
Explanation / Answer
1.
Net operating income of new line
Sales
$ 9,705,000
Less variable expenses @ 65%
$6,308,250
Contribution margin
$3,396,750
Less fixed expenses
$2,591,710
Net operating income
$805,040
Present
New Line
Total
Sales
$ 22,440,000
$ 9,705,000
$ 32,145,000
Net operating income
$ 2,215,400
$ 805,040
$ 3,020,440
Operating assets
$ 4,480,000
$ 2,430,600
$ 6,910,600
Margin (2) ÷ (1)
9.87%
8.30%
9.40%
Turnover (1) ÷ (3)
5.01
3.99
4.65
ROI (4) × (5)
49.45%
33.12%
43.71%
2. Dell Havasi will be inclined to reject the new product line, since accepting it would reduce his division’s overall rate of return.
3. The new product line promises an ROI of 33.12%, whereas the company’s overall ROI last year was only 18%. Thus, adding the new line would increase the company’s overall ROI.
4a.
Present
New Line
Total
Operating assets
$ 4,480,000
$ 2,430,600
$ 6,910,600
Minimum return required
15%
15%
15%
Minimum net operating income
$ 672,000
$ 364,590
$ 1,036,590
Actual net operating income
$ 2,215,400
$ 805,040
$ 3,020,440
Minimum net operating income (above)
$ 672,000
$ 364,590
$ 1,036,590
Residual income
$ 1,543,400
$ 440,450
$ 1,983,850
4b. Under the residual income approach, Dell Havasi would be inclined to accept the new product line, since adding the line would increase the total amount of his division’s residual income, as shown above.
Net operating income of new line
Sales
$ 9,705,000
Less variable expenses @ 65%
$6,308,250
Contribution margin
$3,396,750
Less fixed expenses
$2,591,710
Net operating income
$805,040
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