The major operating divisions of Grey Company are organized as investment center
ID: 2595774 • Letter: T
Question
The major operating divisions of Grey Company are organized as investment centers for performance-evaluation purposes. The division managers are evaluated, in part, on the basis of the change in the return on investment (ROI) of their units. Operating results for the Division A for the coming year, 2016, based on its existing assets are budgeted as follows:
Operating assets for the Division A are currently $3,600,000. For 2016, the division can add a new product line for an investment of $600,000. The new product line is expected to generate sales of $1,600,000 and will incur fixed expenses of $600,000 annually. Variable costs of the new product are expected to average 60% of the selling price.
Required:
1. ROI
a. What is the current ROI?
b. What is the new product line’s ROI?
c. What is the divisional ROI after the new investment
d. How does ROI impact management’s behavior?
2. Residual Income
a. If the required rate of return is 6%, what is the residual income amount?
b. If residual income was used to evaluate this opportunity, how would it impact management’s behavior?
Sales $5,000,000 Less variable costs 2,500,000 Contribution margin 2,500,000 Less fixed expenses 1,800,000 Operating income $700,000Explanation / Answer
1. ROI = (Operating Income / Operating Assets) * 100
a. Current ROI = (700,000 / 3,600,000) * 100 = 19.44%
b. New product line's ROI = (40,000 / 600,000) * 100 = 6.67%
c. Divisional ROI after the new investment = (740,000 / 4,200,000) * 100 = 17.61%
d. ROI impacts management behaviour directly. If the proposed investment increases the rate of return the mangement will undertake the new investment. If not, vice versa. In the given question, adding a new product line is reducing the Divisional ROI from 19.44% to 17.61%. So the management may drop the idea of adding the new product line.
Working Notes:
2.a. Residual Income = Operating Income - (Opearting Assets * Cost of capital )
= 700,000 - (3,600,000 * 6%) = 700,000 - 216,000 = $484,000
b. Residual Income after new product line = 740,000 - (4,200,000 * 6%) = 740,000 - 252,000 = $488,000
If residual income was used to evaluate this opportunity, management may adopt this new product line as it can lead to an increase in operating income by $4,000 (488,000 - 484,000). However the gain in quite minimal.
PARTICULARS NEW PRODUCT LINE DIVISION AFTER NEW PRODUCT Sales 1,600,000 6,600,000 Less: Variable Cost (960,000) (3,460,000) Contribution margin 640,000 3,140,000 Less: Fixed Cost (600,000) (2,400,000)Related Questions
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