10 Check my work Problem 11-18 Return on Investment (ROI) and Residual Income [L

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10 Check my work 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 $22,100,000 Variable bxpenses 13 893,400 8,206,600 Contribution margin Pixed expenses Net operating incone 6,085,000 Divisional average operating assets 5.200,000 The company had an overall return on investment (RO) of 16.00% 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 $2,387,500. The cost and revenue characteristics of the new product line per year would be: Sales variable expenses Fixed expenses 9,550,000 65% of sales $2,578,500 Required:

Explanation / Answer

1. ROI for this year = net operating income/sales * sales/average operating assets = 2,121,600/22,100,000 * 22,100,000/5,200,000 = 40.80%

2. ROI for new product line = net operating income/sales * sales/average operating assets.

Net operating income = sales - variable costs - fixed expenses = 9,550,000 - 65% of 9,550,000 - 2,578,500 = 764,000

Thus ROI = 764,000/9,550,000 * 9,550,000/2,387,500 = 32.00%

3. Net operating income = 2,121,600+764,000 = 2,885,600. Sales = 22,100,000+9,550,000 = 31,650,000. Operating assets = 5,200,000+2,387,500 = 7,587,500

ROI = 2,885,600/31,650,000 * 31,650,000/7,587,500 = 38.03%

4. If i were in Dell's position I would reject the new product line as its ROI is less than the ROI being generated by the division. Its introduction is pulling down the ROI of the division from 40.80% to 38.03%

5. The headquarters is anxious as the ROI of the office product division is much higher at 40.8% when compared to the ROI of 16% for the entire company. They are hoping that by adding a new product line the company's ROI will also increase.

6a: Residual income = Net operating income - (minimum required return*average operating assets) = 2,121,600 - (12% of 5,200,000) = $1,497,600

b. Residual income = 764,000 - (12% of 2,387,500) = 477,500

c. Resdiual income = 2,121,600+764,000 - (12% of 5,200,000+477,500) = 2,204,300

d. Using this approach I would accept the new product line as its introduction is increasing the absloute value of the residual income.

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