\"I know headquarters wants us to add that new product line,\" said Fred Hallowa

Question

"I know headquarters wants us to add that new product line," said Fred Halloway, manager of Kirsi Products' East Division. "But I want to see the numbers before I make a move. Our division's return on investment (ROI) has led the company for three years, and I don't want any letdown." Kirsi Products is a decentralized wholesaler with four autonomous divisions. The divisions are evaluated on the basis of ROI, with year-end bonuses given to divisional managers who have the highest ROI. Operating results for the company's East Division for last year are given below: The company had an overall ROI of 18% last year (considering all divisions). The company's East Division has an opportunity to add a new product line that would require an investment of $3,040,000. The cost and revenue characteristics of the new product line per year would be as follows: Compute the East Division s ROI for last year; also compute the ROI as it would appear if the company performed the same as last year and added the new product line. (Do not round intermediate percentage values. Round other intermediate calculations and final answers to 2 decimal places.) If you were in Fred Halloway's position, would you accept or reject the new product line? Accept Reject Why do you suppose headquarters is anxious for the East Division to add the new product line? Adding the new line would increase the company's overall ROI. Adding the new line would decrease the company's overall ROI. Suppose that the company's minimum required rate of return on operating assets is 15% and that performance is evaluated using residual income. Compute the East Division's residual income for last year; also compute the residual income as it would appear if the company performed the same as last year and added the new product line. Under these circumstances, if you were in Fred Halloway's position would you accept or reject the new product line?

Explanation / Answer

I know headquarters wants us to add that new product line,” said Clem Baker, manager of Westwood Inc.’s Office Products Division. “But I want to see the numbers before I make any move. Our division has led the company for three years, and I don’t want any letdown.”
     Westwood Inc. is a decentralized organization with five autonomous divisions. The divisions are revaluated on the basis of the return that they are able to generate on invested assets, with year-end bonuses given to the divisional managers who have the highest ROI figures. Operating results for the company’s Office Products Division for the most recent year are given below:

                                                                        Present                   New Line               Total
(1)     Sales                                                     $9,000,000           $1000000             $10000000
(2)     Net operating income                       $1,080,000             50000                   1130000             
(3)     Operating assets                             $4,500,000               $250,000               4750000
(4)     Margin (2) ÷ (1)                             12%                            5%                          11.3%
(5)     Turnover (1) ÷ (3)                               2                             4                              2.11
(6)     ROI (4) × (5)                       24%                        20%                        23.85%

        New ROI = 23.85%

a)       They want to expand into new markets and increase their company’s presence.

b)       The new product line is still giving positive return on investment which will add to the overall profitability of company.

                                        = 1080000 – 4500000 * .15 = 405000

   New residual income = Net operating Income - Operating assets *.15

                                        = 1130000  - 4750000 *.15 = 417500

Under residual income approach Clem Baker will be inclined to add new product line because his divison’s residual income is increasing in absolute terms and he performance evaluation is made on absolute increase in income.

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