Return on Investment
The company executives want to add a new product line, but the manager of the South Division wants to see the numbers before making a decision. The division’s return on investment (ROI) has led the company for 3 years, and she believes that should continue.
The company is a decentralized wholesaler with 4 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 South Division for this year are given below:
Sales $ 22,440,000
Variable expenses 14,094,600
Contribution margin 8,345,400
Fixed expenses 6,130,000
Net operating income $ 2,215,400
Divisional average operating assets $ 4,480,000
The company had an overall return on investment (ROI) of 18.00% this year (considering all divisions). Next year the South Division has an opportunity to add a new product line that would require an additional investment that would increase average operating assets by $2,430,600. The forecasted cost and revenue of the new product line per year would be:
Sales $9,705,000
Variable expenses 65% of sales
Fixed expenses $2,591,710
Required:
1.Compute the South Division’s margin, turnover, and ROI for this year.
2.Compute the South Division’s margin, turnover, and ROI for the new product line by itself.
3.Compute the South Division’s margin, turnover, and ROI for next year assuming that it performs the same as this year and adds the new product line.
4.If you were in the manager’s position, would you accept or reject the new product line?
5.Why do you suppose headquarters is anxious for the South Division to add the new product line?
6.Suppose that the company’s minimum required rate of return on operating assets is 15% and that performance is evaluated using residual income.
A. Compute the South Division’s residual income for this year.
B. Compute the South Division’s residual income for the new product line by itself.
C. Compute the South 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 the manager’s position, would you accept or reject the new product line? Explain your answer.